New Delhi: The Reserve Bank of India, which regulates the banking sector in the country, has issued fresh directions to banks, non-banking finance companies and housing finance companies on the levy of penal interest and penal charges on home loans, auto loans and personal loans in order to bring transparency and reduce customer grievances and disputes.
In its direction to banks, NBFCs, housing finance companies, regional rural banks, local area banks, urban-cooperative banks and national financial institutions such as National Housing Bank, NABARD and SIDBI among others, the RBI asked them to ensure reasonableness and transparency in disclosure of penal interest.
Under the existing guidelines, lending institutions have the operational autonomy to formulate Board approved policies for the levy of penal rates of interest. The RBI said that in many instances banks and NBFCs use penal rates of interest, over and above the applicable interest rates, in case of defaults and non-compliance by the borrower with the terms of loans.
According to the RBI, the intent behind the levy of penal interest and penal charges is to inculcate a sense of credit discipline and such charges should not be used as a revenue enhancement tool over and above the contracted rate of interest. However, it has been observed that banks and NBFCs and other regulated entities follow different practices with regard to the levy of penal interest or penalty that leads to customer grievances and disputes in the banking sector.
RBI guidelines on penal charges by banks
The RBI said if the penalty is levied for non-compliance with material terms and conditions of the loan contract by the borrower then shall be treated as a ‘penal charge’ and shall not be levied in the form of ‘penal interest’ that is added to the rate of interest charged on the loan given to a customer.
In other words, there shall be no capitalisation of penal charges. It means there will be no further interest computed on such charges. For example, if a bank or NBFC levies a penalty for non-compliance with a loan agreement then it cannot levy interest on these charges. However, the RBI clarified that this will not affect the normal procedures for compounding interest in the loan account.
Moreover, banks, NBFCs and Housing Finance Companies will not introduce any additional component to the rate of interest. RBI also asked these regulated entities to formulate a Board approved policy on penal charges or similar charges on loans even if they are called by any other name.
Penal charges to be reasonable: RBI
More importantly, the Reserve Bank asked the bank and NBFCs to ensure that the quantum of penal charges shall be reasonable and commensurate with the non-compliance of material terms and conditions of loan contracts without being discriminatory within a particular loan or product category.
Secondly, the penal charges in case of loans sanctioned to individual borrowers, for purposes other than business, will not be higher than the penal charges applicable to non-individual borrowers for similar non-compliance of material terms and conditions.
Moreover, the quantum and reason for penal charges shall be clearly disclosed to the customers in the loan agreement and most important terms and conditions of the Key Fact Statement (KFS). The quantum of penal charges should also be displayed on the website of the concerned bank or NBFC under Interest Rates and Service Charges.
Penal charges to be disclosed in alerts sent by banks
In order to alert the borrowers about any impending penal charges in case of non-payment or default in payment, the RBI has asked the banks and NBFCs to ensure that whenever reminders for non-compliance of material terms and conditions of the loan are sent to borrowers, the applicable penal charges should also be communicated to the customers.
For example, if a bank sends a loan payment reminder to a customer then it should also communicate what penal charges will be levied in case of non-payment before the due date. In addition to informing the customer about any instance of levy of penal charges, the banks and NBFCs should also disclose the reason for the same.
New instructions to take effect from January 2024
The RBI has given more than four months time to banks and NBFCs to follow the new guidelines and they will come into effect from January 1, 2024. In the meantime, banks, NBFCs and HFCs have been asked to carry out appropriate revisions in their policy framework and ensure implementation of the instructions in respect of all the fresh loans availed and renewed from the effective date.
However, in the case of existing loans, the switchover to the new penal charges regime shall be ensured on the next review or renewal date or six months from the effective date of this circular.
New rules not applicable to Credit Cards
Though new rules are aimed at bringing transparency and fairness in case of the levy of penal charges by banks and NBFCs several loan categories have been kept out of these new instructions. For example, these instructions will not apply to Credit Cards, External Commercial Borrowings (ECBs), Trade Credits and Structured Obligations which are covered under product-specific directions.
Instructions issued under RBI Act of 1934
These fresh instructions on the levy of penal charges by banks have been issued by the RBI under Sections 21, 35A and 56 of the Banking Regulation Act of 1949, Sections 45JA, 45L and 45M of the Reserve Bank of India Act of 1934, and Section 30A of the National Housing Bank Act of 1987.
