The Reserve Bank of India (“RBI”), on August 18, 2023, released instructions on penal charges in loan accounts under ‘Fair Lending Practice- Penal Charges in Loan Accounts’ (the “Instructions”). RBI has previously issued various guidelines to the Regulated Entities (“REs”) to ensure reasonable and transparent disclosure of penal interest.
1. What has happened so far in the penal charges landscape?
Under the existing RBI guidelines, lending institutions had the operational autonomy to formulate board-approved policies for the levy of penal rates of interest. It was observed that many REs used penal rates of interest, over and above the applicable interest rates, in case of defaults by the borrower.
To understand what went down in the penal interest on loans regime, read a two-part article on ‘RBIs regulation of interest rate and penal charges: Next financial regulatory hot topic in India?’ Part I and Part II, authored by our founding partners, Kritika Krishnamurthy and Anuroop Omkar. The article explains the background surrounding the interest rates and penal charges on loan accounts and RBI’s regulation of the same.
2. What is the scope of applicability of the latest Instructions by RBI?
The latest Instructions by RBI shall apply to all REs, including all commercial banks (including small finance banks, local area banks and regional rural banks), all primary (urban) co-operative banks, all Non-Banking Financial Companies (“NBFCs”), including housing financial companies and all India financial institutions such as EXIM bank, NABARD, NHB, SIDBI and NaBFID.
Further, these Instructions shall not apply to payment banks. It shall also not apply to credit cards, external commercial borrowings, trade credits and structured obligations as they are covered under product-specific directions.
3. What are the key takeaways from the latest Instructions by RBI?
As per the recent RBI Instructions, the REs will be required to adopt the following practices-
- No more ‘penal interest’; ‘penal charges’ to take place: REs shall ensure that if a penalty is charged for non-compliance of material terms and conditions of the loan contract by the borrower, it shall be treated as ‘penal charges’ and shall not be levied in the form of ‘penal interest’ which gets added to the rate of interest charged on the advances.
- No capitalisation of penal charges: REs shall ensure that no further interest is computed on such penal charges. (This would not affect the other normal procedures for compounding interest in the loan account.)
- No other component to interest rate: REs shall ensure not to introduce any additional component to the interest rate.
- Adoption of the Instructions: REs shall ensure to comply with these guidelines in both letter and spirit, meaning REs will have to adhere to and change its existing penal charges norms in practice.
- Board-approved policy: REs shall ensure to form a board-approved policy on penal charges or any other similar charges in practice.
- Reasonable penal charges: REs shall ensure that the quantum of penal charges is reasonable and commensurate with the non-compliance of material terms and conditions of a loan contract. REs shall also ensure that such penal charges are not discriminatory within a particular loan category.
- Disclosure of penal charges: REs shall ensure to disclose the quantum and reason for penal charges, important terms and conditions and key fact statements to the customers in the loan agreement. REs shall also display the same on their website under the Interest Rates and Service Charges section.
- Timely reminders: REs shall ensure to communicate the applicable penal charges to the borrowers whenever reminders for non-compliance of material terms and conditions of the loan are sent to such borrowers.
4. When are the REs required to adopt the changes in the penal charges regime?
The recent Instructions by RBI on levying penal charges shall come into effect from January 01, 2024. REs has almost 4 (four) months to carry out changes in their policy framework and ensure implementation of the Instructions.
5. Are these Instructions retrospective or prospective in nature?
RBI has mentioned that the REs shall implement the Instructions regarding all fresh loans availed or renewed from the effective date.
However, in the case of the loans already existing, REs shall make a switchover to the new penal charges regime on-
- the next review or
- renewal date, or
- six months from the effective date of this instruction (whichever is earlier).
6. Which Master Directions or Master Circulars applicable to REs shall be updated or amended?
Once these Instructions are implemented, the following Master Directions or Master Circulars applicable to the REs shall be amended-
- Master Direction- Reserve Bank of India (Interest Rate on Advances) Directions, 2016, dated March 03, 2016;
- Master Direction- Non-Banking Financial Company- Non-Systemically Important Non-Deposit taking Company (Reserve Bank) Directions, 2016, dated September 1, 2016;
- Master Direction- Non-Banking Financial Company- Non-Systemically Important Non-Deposit taking Company and Deposit taking Company (Reserve Bank) Directions, 2016, dated September 1, 2016;
- Master Direction- Non-Banking Financial Company- Housing Finance Company (Reserve Bank) Directions, 2021, dated February 17, 2021;
- Master Circular- Management of Advances-UCBs dated July 25, 2023;
- Master Circular- Customer Service in Banks dated July 1, 2015; and
- Master Circular- Loans and Advances- Statutory and Other Restrictions dated July 1, 2015.
Disclaimer
The note is prepared for knowledge dissemination and does not constitute legal, financial or commercial advice. AK & Partners or its associates are not responsible for any action taken based on its contents.
