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

RBI has tweaked norms on loan penal charges imposed by banks on defaulting borrowers

The Reserve Bank of India (RBI) on August 18 tweaked the norms related to banks imposing penalties on loan accounts for violation of contractual terms by the borrower. The central bank said banks cannot treat such penalties to raise revenues.

The RBI said banks must treat penalty for non-compliance as ‘penal charges’ and not be levied in the form of ‘penal interest’ that is added to the rate of interest charged on the advances. Besides, the central bank has announced a host of changes in the rules that will come into effect from  January 1, 2024.

What does the RBI say?

According to the central bank, 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.

While the intent of levying penal interest is essentially to inculcate a sense of credit discipline, supervisory reviews have indicated divergent practices amongst banks, the RBI said. "Such charges are not meant to be used as a revenue enhancement tool over and above the contracted rate of interest," the central bank said.

The RBI's observations are critical as customers have been complaining about lack of transparency on the part of banks while imposing penal charges on customers.

The regulator said banks should not introduce any additional component to the rate of interest and ensure compliance to these guidelines in both letter and spirit.

Further, banks need to formulate a coard approved policy on penal charges or similar charges on loans, the central bank added.

"The quantum of penal charges shall be reasonable and commensurate with the noncompliance of material terms and conditions of loan contract without being discriminatory within a particular loan product category," the RBI added.

More importantly, the RBI said the penal charges in case of loans sanctioned to individual borrowers, for purposes other than business, should not be higher than the penal charges applicable to non-individual borrowers for similar non-compliance of material terms and conditions.

Focus on transprency

Further, the central bank said the quantum and reason for penal charges needs to be clearly disclosed by banks to the customers in the loan agreement and most important terms and conditions as applicable, in addition to being displayed on the banks' website under Interest rates and Service Charges.

Further, whenever reminders for non-compliance of material terms and conditions of loan are sent to borrowers, the applicable penal charges needs to be communicated, the RBI said.  Banks should also communicate any instance of levy of penal charges and the reason, the regulator said.

Banks asked to prepare 

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

In the case of existing loans, the switchover to new penal charges regime shall be ensured on 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.