MC Explains: What do RBI's new draft rules on loan penal charges say?

RBI released draft rules on loan penal charges on April 12

The Reserve Bank of India (RBI) on April 12 released draft rules on penal charges related to loans for banks and other financial institutions (FIs). RBI Governor Shaktikanta Das, during the monetary policy announcement in February, had said that these guidelines will be released soon.

The central bank, while releasing the draft rules , releasing the draft rules, observed that many regulated entities (REs) use penal rates of interest over and above the applicable interest rates in case of defaults or non-compliance by the borrower with the terms on which credit facilities were sanctioned.

So what do the new rules mean for FIs? Are there any changes in penal and interest rate charges levied by REs on borrowers? Should a borrower be worried? Here’s an explainer.

First of all, what are the new draft rules about?

The new draft rules, which are open for comments till May 15, 2023, guided FIs like banks, non-banking financial companies (NBFCs) and housing finance companies (HFCs) to communicate all the details on penal charges, interest rates on late repayment, policy of the financial institutions, etc., to the borrowers.

The rules focused on details of the penal charges levied by FIs, terms and conditions of the penal charges, modification of interest rate in line with regulatory orders, etc.

Also read: RBI releases draft rules on penal charges related to loans

Rules on penal charges

The rule said that for all FIs, any penalty charged in the case of a default or for non-compliance with terms and conditions of the loan contract by the borrower is to be treated as a penal charge. Additionally, the rule clarified that these charges are not to be added in the interest that the borrower pays on the loan on a monthly or yearly basis, whichever is applicable.

Further, the draft said that all FIs must have a board-approved policy on penal charges or similar charges applied on loans.

FIs, when levying a penal charge on default or non-compliance by the borrower, should ensure that the penal charge should be proportional to the default amount and in line with the agreed terms and conditions of loan contract.

“This threshold is to be determined by the REs and shall not be discriminatory within a particular loan or product category,” the draft rules said.

Banks, NBFCs and HFCs also have to ensure that no further interest should be charged on penal charges. And the penal charges in the 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.

Also read: RBI Policy: Draft guidelines on levy of penal charges on loans in the works

Any FI, when communicating reminders for payments or instalments to the borrower, shall also communicate the applicable penal charges on default.

Other than this, banks, NBFCs and HFCs also need to clearly disclose all the details of the penal charges in the loan agreement in addition to the same communicated on the websites of the respective FIs.

Draft penal rules

The new draft rules, in an important development, stated that any FI found levying ‘penal charges’ in place of ‘penal interest’ will be subject to appropriate review during supervisory examinations by the RBI.

Rules on interest rate

No FI should introduce any additional component to rate of interest. In other words, the determination of the interest rate will be strictly governed by the relevant regulatory instructions which should not invite changes from REs.

“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," said the draft rules.

REs can alter credit risk premium under the interest charges by the lender. The draft rules mentioned that the alteration can only happen when the credit risk profile of a borrower changes.

“REs will be free to alter credit risk premium as per the contract terms and conditions, in terms of extant instructions,” the draft rules said.