Penal charges, not penal interest: How RBI circular is set to help borrowers

The RBI has asked banks to carry out appropriate revisions in their policy frameworks and ensure implementation of the instructions with respect to all loans availed or renewed from the effective date.

The Reserve Bank of India’s (RBI) circular on banks imposing penalties on loan accounts for violation of contractual terms by the borrower will bring in a strict regime of ‘penal charges’, experts said.

On August 18, the central bank said banks must treat penalties for non-compliance as ‘penal charges’ and not levy them in the form of ‘penal interest’ that is added to the rate of interest charged on the advances. The banks cannot treat such penalties to raise revenues, RBI said.

Experts said that the RBI circular will bring in strict regulation of penal charges as now a fixed board-approved policy must be in place.

“One may see some reduction in the penal charges. Now the charges will be closely regulated though we do not see much impact on the industry,” said Damodaran C, Chief Risk Officer, Federal Bank.

Only those banks in which the central bank found irregularities will work on changing the charges, Damodaran said.

"The RBI circular could lead to a more transparent and predictable fee structure, helping borrowers understand the potential penalties better," said Nitin Purswani, CEO, Medius AI, a debt management company.

Narendra Kumar, Co-Founder, Enterslice, a BFSI consultant company, said the central bank’s initiative aims to bridge the trust gap by bringing in uniformity and fairness in handling these charges.

“This will be beneficial for borrowers as they have been complaining about this,” Kumar said.

Also read: Penalty on loan accounts: RBI tweaks norms, asks banks not to use levy to boost revenue

What is the RBI circular?

There should not be capitalisation of penal charges, meaning no further interest computed on such charges, the RBI clarified, mentioning that this will not affect the normal procedures for compounding of interest in the loan account.

The RBI announced the change after observing that many banks 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.

“The intent of levying penal interest/charges is essentially to inculcate a sense of credit discipline and such charges are not meant to be used as a revenue enhancement tool over and above the contracted rate of interest,” the RBI said in a circular.

Here, Kumar said: “While regulated entities (REs) have the authority to determine penal charges, it's crucial for them to maintain a high level of reasonableness.”

Banks asked to prepare

The RBI has asked banks to carry out appropriate revisions in their policy frameworks and ensure implementation of the instructions with respect to all loans availed or renewed from the effective date.

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, whichever is earlier, the RBI said.

However, these instructions do not apply to credit cards, external commercial borrowings, trade credits and structured obligations which are covered under product-specific directions, the RBI added.

But Damodaran highlighted that there is a need for clarification from the regulator on the uniformity of the penal charges.

“There needs to be a clarification on whether penal charges would be fixed or different from case to case,” Damodaran said.

Purswani said: "Lenders might face challenges in implementing the new rules, especially those used to leveraging penal interest as a revenue stream. They will have to review and possibly overhaul their existing systems to comply with the new regulations."