The story so far: Central banking regulator Reserve Bank of India (RBI) on April 12 introduced for public consultation draft guidelines for the levy of ‘penal charges’ instead of the existing ‘penal interest’ imposed by banks on customers for defaulting on loan payments. The guidelines were issued following an announcement made (on February 8) in the Statement on Developmental and Regulatory Policies. Stakeholders can send their comments to the regulator by May 15.
What are the provisions?
According to the draft guidelines, penalties charged for default on interest payments or non-compliance of material terms and conditions of loan contract by the borrower would now be accrued as ‘penal charges’ instead of ‘penal interest’. The latter was levied in addition to the rate of interest charged on borrowings.
To put it simply, lending entities would not be able to levy an ad-hoc additional penal rate of interest over and above the applicable rate of interest.
For perspective about penal interest: say the borrower’s EMI payment for the month of April is Rs 1,000 at 10% interest rate. They default on making a timely EMI payment which subjects them to an additional interest payment of 24% per annum (or 2% per month) over and above the interest component (at 10% of principal amount) already payable that month.
The draft guidelines direct that ‘penal interest’ (at 2% p.a. in the example) be replaced with an ‘penal charge, with no additional component to the rate of interest. RBI also stated in the circular that there shall be no capitalisation of penal charges, that is, it shall be levied separately and not be added to the principal outstanding amount.
The quantum of penal charges must be proportional to the defaults or non-compliance of material terms and conditions of a loan contract up to a certain threshold. This is to be determined by the lending entities themselves and must not be discriminatory within a particular loan/product category.
The penal charges for loans to individual borrowers, for non-business purposes, cannot be higher than the penal charges applicable to companies and organisations. This must be disclosed to the customers in the loan agreement and the Key Fact Statement (KFS), while also being displayed on their websites, enlisting the various interest rates and service charges.
The instructions however do not apply to credit because, as stated by the regulator, these are covered under product specific directions.
Why were they necessary?
Per the regulator, the intent behind levying penal interest/charges was to inculcate credit discipline among borrowers through negative incentives and in turn, ensure fair compensation to the lender. They are not to be used as a revenue enhancement tool above the contracted rate of interest. The present guidelines state that regulated entities have operational autonomy to formulate board-approved policy for levy of penal interest which must be “fair and transparent”.
Arguing against the levy of GST on penal interest, Bajaj Finance submitted before the Maharashtra Appellate Authority for Advance Ruling for Goods and Services Tax (2018-19), that penal interest reflects the time value of money. When the financial institution grants a loan to a customer, they earn interest which represents a certain consideration for the use of money during the specified period. Thus, the levy of additional interest, or penal interest, is provided for the use of money beyond the stipulated date.
Separately, RBI mentioned in its ‘Statement on Developmental and Regulatory Policies’ that supervisory reviews had indicated divergent practices in the levy of penal interest. These were excessive in certain cases, leading to customer grievances and disputes.
According to Adhil Shetty, CEO at BankBazaar, “With the new circular, the RBI is clear it doesn’t want penalties to compound as interest. Not every lender does it, but now the RBI wants conformity. This can be seen as a borrower-friendly move.”
Mr Shetty said the regulator’s measures towards credit awareness is “laudable”.
“For a while now, the central bank has been highlighting the need for lenders to communicate clearly to borrowers on various loan charges,” he added, pointing to the Digital Lending Framework issued last year, followed by the Credit and Debit card - Issuance and Conduct Directions (in December 2022) which did away with negative amortisation of penalties for credit cards.
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