Introduction

The Reserve Bank of India (“RBI”) in its press release titled ‘Statement on Developmental and Regulatory Policies’[1], dated 8th February 2023 observed divergent practices amongst regulated entities, such as commercial banks, primary (urban) co-operative banks, non-banking financial companies (NBFCs), and other financial institutions (collectively “REs”) pertaining to charging of penal interest. It was observed that, penal interest was being used as a revenue enhancing tool and charged over and above the contracted rate of interest in certain cases. To combat such practices, address borrowers’ complaints, and instil transparency, the RBI issued a circular titled ‘Fair Lending Practice – Penal Charges in Loan Accounts’ dated 18th August 2023 (“Circular”)[2].

Effective 1st January 2024, REs are required to transition from the existing practice of imposing ‘penal interest’ to the concept of ‘penal charges’ that is added to the rate of interest charged on the advances, in the event of non-compliance with material terms and conditions on which credit facilities are granted by lenders to borrowers.

The shift away from penal interest is to enforce the philosophy that penal charges should be levied to encourage a sense of credit discipline and not to be used as a tool to enhance revenue. Penal interest can potentially take the shape of a punitive measure, therefore penal charges are introduced as an endeavour to urge borrowers to comply with the terms of their loans and inculcate a sense of credit discipline and in doing so, enhance transparency in the lending market.

Understanding the difference: Penal Interest and Penal Charge

The RBI mentioned in the Circular that as a matter of practice, the penal interest was imposed over and above the interest rates of the facility agreement. Such practise often culminates into accumulated penal interest surpassing the principal amount of the facility. With the objective to address borrowers’ grievances, the RBI instructed the levy of penalty for default by borrowers as penal charges and not as penal interest.

The Circular makes it apparent that penal charge is a nomenclature, for charges imposed by loan providers in relation to loans, including charges levied for non-compliance of material terms and condition of a loan agreement, and any such similar charge. Unlike a penal interest, a penal charge is not be added to the rate of interest charged on the advances provided by a lender to a borrower under a loan agreement.

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RBI’s Directive

• In the event a penalty is charged for non-compliance of material terms and conditions, it is to be levied only in the form of penal charge. Further, penal charge is not be added to the rate of interest charged on the advances.
• Capitalisation of penal charges is prohibited, however, RBI has clarified that this will not affect compounding of interest in the loan account.
• To ensure the Circular is followed in letter and spirit, REs have been prohibited from introducing any additional component to the rate of interest.
• REs are required to have a board approved policy on penal charges or similar charges.
• The quantum of penal charge is to be reasonable and commensurate with the non-compliance of material terms and conditions of a loan contract, without discriminating within a particular loan / product category.
• Penal charges applicable to loans to individual borrowers (“IBs”) (for purposes other than business) should not be higher than the penal charges applicable to non-IBs for similar non-compliance of material terms and conditions.
• The quantum and reason for penal charges is required to be disclosed by the REs to their customers in the loan agreement and most important terms and conditions / key fact statement (KFS) as applicable. Additionally, REs are required to display such information on their respective websites under the 'interest rates and service charges’ portion.
• While sending any reminders for non-compliance of material terms and conditions of loan agreement, the REs are required to communicate the applicable penal charges to the borrower.
• As an exception these instructions are not applicable to credit cards, external commercial borrowings, trade credits, and structured obligations.

Room for clarity and points for consideration

The Circular does not provide any definition of 'non-compliance of the material terms and conditions'. This could lead to ambiguity and varying interpretations of what constitutes breach of a material term or condition. Furthermore, the test to determine materiality is also not clearly stipulated and would therefore depend upon the contractual terms of each contract.

It may be noted that, though the background to the Circular and draft guidelines refers to penal interest / charges on both ‘default’ and ‘non-compliance' by the borrower with the terms on which credit facilities were sanctioned’, the operating part of the Circular only refers to ‘non-compliance of material terms and conditions’. This opens room for interpretation for treatment of a payment-related default and whether capitalization of interest in relation to a payment default is permissible or not.

While the notification states exemption for trade credits, in our view the intention is to cover overseas trade credits under RBI’s Master Direction - External Commercial Borrowings, Trade Credits and Structured Obligations and not the domestic market trades.

Conclusion

By differentiating between penal charges and penal interest, the RBI aims to cultivate a more equitable lending market. However, challenges remain in terms of clarity on certain key factors as discussed. This Circular on penal charges is a welcome development for borrowers, but it could be improved to provide greater clarity and transparency. The RBI might need to monitor the implementation of the Circular closely to ensure that it is effective in protecting borrowers and promoting fair lending practices.

Author: Ankit Sinha,Rupul Jhanjee and Sangha Nath

Footnotes

[1] https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=55179

[2] https://rbi.org.in/Scripts/NotificationUser.aspx?Id=12527&Mode=0