Explained: The RBI Draft Circular on Fair Lending Practice on Penal Charges

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The quantum of penal charges shall be proportional to the defaults/ non-compliance of material terms and conditions of loan contract beyond a threshold. This threshold is to be determined by the REs and shall not be discriminatory within a particular loan / product category.

Chandigarh (ABC Live): The Reserve Bank on April 12, 2023 released a Draft Circular on Fair Lending Practice on Penal Charges in Loan Accounts charged by financial institutions.

The Draft Circular says that, “The Reserve Bank has issued various guidelines to the Regulated Entities (REs) to ensure reasonableness and transparency in disclosure of penal interest.

Under the extant guidelines, lending institutions have the operational autonomy to formulate Board approved policy for levy of penal rates of interest.

It has been observed that many REs use penal rates of interest, over and above the applicable interest rates, in case of defaults / non-compliance by the borrower with the terms on which credit facilities were sanctioned.

The intent of levying penal interest/charges is essentially to inculcate a sense of credit discipline among borrowers through negative incentives and to ensure fair compensation to the lender.

Penal interest/charges are not meant to be used as a revenue enhancement tool over and above the contracted rate of interest.

However, supervisory reviews have indicated divergent practices amongst the REs with regard to levy of penal interest/charges leading to customer grievances and disputes.

On a review of the practices followed by REs for charging penal interest/charges on loans, the following instructions are issued for adoption.

Determination of interest rates on credit facilities, including conditions for reset of interest rates, will be strictly governed by the relevant regulatory instructions issued in this regard. REs shall not introduce any additional component to rate of interest.

Penalty, if charged, for default / non-compliance of material terms and conditions of loan contract by the borrower shall be treated as ‘penal charges’ and shall not be levied in the form of ‘penal interest’ that is added to the rate of interest charged on the advances. There shall be no capitalisation of penal charges, i.e, no further interest computed on such charges. However, this will not affect the normal procedures for compounding of interest in the loan account.

It needs to be recognised that the rate of interest on a loan includes appropriate credit risk premium reflecting the credit risk profile of the borrower. If the credit risk profile of the borrower undergoes change, REs will be free to alter credit risk premium as per the contracted terms and conditions, in terms of extant instructions.

The quantum of penal charges shall be proportional to the defaults/ non-compliance of material terms and conditions of loan contract beyond a threshold. This threshold is to be determined by the REs and shall not be discriminatory within a particular loan / product category.

The penal charges in case of loans sanctioned to individual borrowers, for purposes other than business, shall not be higher than the penal charges applicable to non-individual borrowers.

 Penal charges and the conditions precedent therefor, shall be clearly disclosed by REs to the customers in the loan agreement and most important terms & conditions / Key Fact Statement (KFS) as applicable, in addition to being displayed on REs website under Interest rates and Service Charges.

Whenever reminders for payment of instalments are sent to borrowers, the applicable penal charges, shall also be communicated.

The REs shall ensure that there is a clearly laid down Board approved policy on penal charges or similar charges on loans, by whatever name called.

The operationalisation of the ‘penal charges’ in place of ‘penal interest’ will be subject to appropriate review during supervisory examination by the RBI.

These instructions shall come into effect from a date to be indicated in the final circular and REs may carry out appropriate revisions in their policy framework and ensure implementation from the effective date.

The above instructions shall not apply to Credit Cards which are covered under product specific directions.

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