Introduction

On 18 August 2023, the Reserve Bank of India (RBI), through its circular on 'Fair Lending Practice - Penal Charges in Loan Accounts' (Circular), issued instructions to regulated entities (REs) i.e., banks and non-banking financial institutions (NBFCs), to ensure reasonableness and transparency in levy of penalty in its lending practices. Through the Circular, the RBI has examined the current market practices around charging default interest by REs upon the occurrence of default or breach of material terms of the lending and issued directions in relation to the levying of penalty by REs.

Historically, the RBI has permitted REs to determine their own policies on penal charges / interest, along the lines of the broad guidelines prescribed by it in this regard. The RBI is of the view that penal charges / interest should not be used as a revenue enhancement tool over and above the contracted interest rate and that it must primarily be levied to: (a) inculcate a sense of credit discipline among borrowers through negative incentives; and (b) ensure fair compensation to REs. In furtherance of this object and in light of the varied practices adopted by REs in respect of default interests, the RBI earlier this year released the 'Draft Circular on Fair Lending Practice – Penal Charges in Loan Accounts' on 12 April 2023 (Draft Circular).

Key regulatory changes

Pursuant to the Draft Circular, the final Circular has now been published and issues the following instructions for REs:

  1. Applicability and effectiveness.
    1. The Circular is applicable to all loans granted by REs, except credit cards, external commercial borrowings, trade credits and structured obligations, which shall be governed by their product specific directions issued by the RBI.

    2. The Circular will be effective from 1 January 2024 (Effective Date) as per the following timelines: (i) all fresh loans availed or renewed from the Effective Date must be compliant with the Circular; and (ii) the existing loans must be compliant with the Circular by the earlier of the renewal date (of the loan) or 6 (six) months from the Effective Date. This gives REs around 4 (four) months to review and revise their loan documentation to ensure compliance with the Circular.

  2. Penal Charges v Penal Interest

    1. The penalty for non-compliance with material terms of the loan is now required to be levied as a 'penal charge' (i.e., a pre-determined standalone amount notified to the borrower prior to or at the time of sanction of the loan) as opposed to the widely practiced levy of 'penal interest' above and beyond the interest charged on the loan.

    2. The barring of the levy of penal interest in this context is coupled with clear instructions to ensure that there should be no capitalization, i.e., further interest computed on penal charges.

    3. The RBI has, as an additional layer of catch-all protection, clarified that no additional components should be introduced to calculate a borrower's rate of interest in relation to breach of material terms of the loan agreement by the borrower, cementing the position that penalty upon the non-compliance of material terms of the loan contract cannot be charged by way of an interest component.

    4. The RBI has further dictated that the quantum of penal charges levied must be commensurate with the non-compliance of the material terms of the loan agreement without being discriminatory for borrowers of the same category of loan / product. It has been specifically clarified that the penal charges for loans sanctioned to individual borrowers for purposes other than business, should not be higher than for non-individual borrowers for similar non-compliance of material terms.

  3. Disclosures
    1. The quantum and rationale for penal charges must be disclosed by REs to borrowers in the loan agreement, most important terms and conditions / key facts statement (as applicable), and on the RE's website under a specific head 'Interest Rates and Service Charges'.

    2. Penal charges and the reason thereof must also be communicated to borrowers along with the rationale at the time of being levied and at the time of sending reminders for non-compliance of the material terms of a loan agreement.

  4. Formulation of Board approved policy

    REs are also required to formulate a policy (by whatever name called) for levy of penal charges on loans, which must be approved by their Board.

Comment

The Circular marks an important change in the structuring of default penalty by REs. The levying of default 'interest' above and beyond the regular interest on a loan has been a well-entrenched market practice, which would now need to be re-evaluated and adopted in the form of a reasonable, uniform, and documented penal charge across the board of each loan category.

Additionally, the Circular also officially settles the position on the oft-argued 'interest on interest' clause between the lenders and borrowers. This refers to the scenario where lenders would insist on the default interest amount becoming a part of the entire loan outstandings on which the regular interest would be charged. This would lead to the interest being charged on the default interest amount as well. Borrowers would often push back on this position, arguing that no interest should be charged on the default penalty which was anyway an additional interest over and beyond the interest. As set out in paragraph 2(b) above, the RBI has now specifically restricted capitalization i.e., charging of further interest on penal charges.

Another impactful change introduced under the Circular would be the requirement of notifying the borrower each time a penal charge is levied and the reason for such levy. By clarifying this position, the RBI has added the onus on the REs to stringent monitor non-compliances by borrowers. The RBI has also created a first level deterrent against charging of ambiguous and arbitrary penalties for breach of terms.

From the perspective of the REs, the first order of business would be to formulate and adopt the Board approved overarching policy which would address the relevant penal charges corresponding to each material non-compliance, the manner in which such charges would be levied, the appropriate triggers and monitoring mechanisms to operationalize such charges, etc. This should be accompanied by: (i) updating the standard loan terms to ensure compliance with the Circular; and (ii) appropriate liaising with existing borrowers to communicate the changes to the terms of their borrowing and amending their loan documentation, as required.

The Circular is a significant stride towards safeguarding the interests of borrowers in the ever-evolving landscape of lending practices. Notably, the Circular marks a departure from the RBI's approach of not issuing specific instructions on the way REs may formulate their policies on penal interest / charges, by permitting REs to only levy penal charges for non-compliance with material terms and conditions of the loan agreement by borrower.

By entrenching clear communication practices and creating accountability through the requirement for a Board-approved policy on levying of penal charges by REs, the RBI has attempted at infusing transparency into the inherent information asymmetry in the lender – borrower relationship. The Circular not only aligns with the RBI's overarching mission of consumer protection but also heralds a potentially more equitable lending landscape for all stakeholders involved.

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