The Reserve Bank of India (“RBI”) recently issued instructions on practices to be adopted for charging penal interest/ charges on loans, vide its notification dated August 18, 2023, titled ‘Fair Lending Practice – Penal Charges in Loan Accounts’ (“Circular”).
The RBI had, in February 2023, issued a ‘Statement on Developmental and Regulatory Policies’ (“Statement”), and a draft circular for comments, dated April 12, 2023 (“Draft Circular”), stipulating that any penalty levied due to delay/ default in servicing a loan, or any other non-compliance of material terms and conditions of a loan contract, by a borrower, shall be levied in the form of ‘penal charges’, in a reasonable and transparent manner, and not in the form of ‘penal interest’ that is added to the rate of interest being charged on the advances made.
Interest rates charged by Indian banks (other than their foreign branches) are governed by, inter alia, the RBI (Interest Rate on Advances) Directions, 2016, as amended from time to time (“Interest Rate Master Direction”). The Interest Rate Master Direction provides (a) that pricing is required to be linked to benchmark rates, which may be internal (for instance, Marginal Cost of Funds based Lending Rate (MCLR), as determined in accordance with the Interest Rate Master Direction), or external (for instance, the RBI policy Repo Rate or any other benchmark market interest rates published by the Financial Benchmarks India Private Limited), and (b) instructions for charging of spread to a customer.
The Interest Rate Master Direction also set outs that banks shall formulate a board approved policy for charging penal interest, which shall (a) be fair and transparent, (b) account for incentive(s) to service the debt, and (c) have due regard for genuine difficulties of borrowers.
The RBI does not similarly regulate the interest rates charged by non-banking financial companies (“NBFCs”). NBFCs are, instead, required to adopt an interest rate model that accounts for factors relevant to pricing, such as cost of funds, margin and risk premium. However, the RBI had received a plethora of grievances related to NBFCs charging high interest, and hence, the banking sector regulator had previously required NBFCs to mention and highlight the penal interest charged for late repayments in terms of loan agreement(s) executed by their borrowers.
Accordingly, banks and NBFCs typically levy penal interest between 1% (one per cent) and 2% (two per cent) per annum on the amount(s) due under the relevant loan agreement, in addition to the applicable interest rate on the loan.
The prescription to levy penalties in the form of penal charges, in terms of the Statement and the Circular, is a departure from the RBI’s previous notifications and publications, under which, inter alia, penalty in the form of penal interest was previously permitted to be levied and had been described as representing additional interest charged to the borrower over and above the normal interest rates. In view of the above, pursuant to the Circular, the provisions in the Interest Rate Master Direction pertaining to penal interest stand deleted, and the relevant master directions issued by the RBI shall be correspondingly amended to permit the levying of penalty in the form of penal charges only.
The Circular applies to all commercial banks (including small finance banks, local area banks and regional rural banks, but excluding payments banks), primary (urban) co-operative banks, all non-banking finance companies (including housing finance companies) and financial institutions. While the Circular covers within its ambit all loans (including digital lending), which the aforementioned entities are permitted to sanction, it specifically excludes credit cards, external commercial borrowings, trade credits and structured obligations, as lending practices with regard to such products are governed by specific directions issued by the RBI.
Overview of the Instructions
The Circular provides that penalty, in the form of penal charges, may be levied only in case of non-compliance of material terms and conditions of a loan agreement by a borrower. Additionally, there is now an explicit prohibition on capitalisation of penal charges, i.e., penal charges being added to the principal amount(s) due, upon which interest may accrue.
The regulated entities to which the Circular applies are also prohibited from introducing additional components to the rate of interest charged, and they are required to ensure compliance with the instructions contained in the Circular, in both letter as well as spirit.
Additionally, penal charges applicable to individual borrowers, with respect to loans for purposes other than business, cannot exceed those applicable to corporate borrowers for similar non-compliances of material terms and conditions of the relevant loan agreements.
Key Differences to the Draft Circular
The Draft Circular, inter alia, provided that penal interest/ charges is/ are intended to “inculcate a sense of credit discipline among borrowers through negative incentives and to ensure fair compensation to the lender.” The idea of such penalty being ‘negative incentives’ and ensuring ‘fair compensation’ to the lender has, however, been dropped from the Circular in view of the numerous customer grievances and disputes arising due to such penalty.
Furthermore, in view of fairness, the quantum of penal charges that may be levied shall be reasonable and commensurate with the extent of non-compliance of the material terms and conditions of the loan agreement, without it being discriminatory within a particular loan/ product category. The Draft Circular had earlier provided that such non-compliance must be beyond a certain threshold determined by the lender; however, such requirement has been done away with in the Circular.
Compliance and action points for lenders
The regulated entities to which the Circular applies will now be required to:
- formulate board approved policies on penal charges or similar charges on loans, including, but not limited to, defaults that may attract penal charges, principles for determination of such charges and their quantum;
- disclose the quantum and reason for penal charges to customers in the loan agreements entered into between the parties;
- display critical terms and conditions on penal charges on their website, under the head ‘Interest rate and Services Charges’; and
- at the time of sending reminders to borrowers with respect to non-compliance of material terms and conditions of the loan, communicate the applicable penal charges, and at the instance of levying of such penal charges, also mention the reason for the same to the relevant borrower.
Effectiveness and way forward
The instructions set out in the Circular are set to take effect on January 01, 2024. Regulated entities to which the Circular applies must ensure compliance with respect to fresh loans from the said date. However, in case of existing loans, the levy of only penal charges shall be ensured in the next review or on the next renewal date or within 6 (six) months from the effective date of the Circular, whichever is earlier. Consequently, such entities are expected to commence the process to ensure compliance with the terms of the Circular.
The Circular is expected to make the levying of penal charges on borrowers, by lenders regulated by the RBI, more fair and transparent, break discriminatory patterns, and address customer grievances, thereby leading to better access to credit for all.
For further information, please contact:
Leena Chacko, Partner, Cyril Amarchand Mangaldas