Background

The Reserve Bank of India (‘RBI’) has from time to time issued various guidelines for regulated entities^[1] in connection with reasonableness and transparency in disclosure of penal interest. The RBI has observed that many regulated entities have used penal rate of interest, over and above the applicable interest rates, in case of default by a borrower of the terms and conditions on which credit facilities are availed by them.

Key Changes

With a view to streamline the divergent practices followed by the regulated entities, on charging of penal interest/charges, RBI has, by way of its Circular dated August 18, 2023, issued the following instructions in relation to charging of penal interest/charges:

i.    The penalty, if charged, by regulated entities for non-compliance of material terms and conditions of the loan contract will now be treated as ‘penal charges’ and will not be levied as ‘penal interest’ that is added to the rate of interest charged on the loan / credit facilities;

ii.   There will be no capitalization of penal charges, i.e., no interest will be computed on such charges. However, normal procedure for compounding interest in the loan account can be continued;

iii.  Regulated entities are required to communicate the applicable penal charges to the borrowers whenever reminders for non-compliance of material terms and conditions are sent. Further, any instance of levy of penal charges and reason for the same will also be communicated;

iv.   Regulated entities will not introduce any additional component to the rate of interest and ensure complete compliance with these instructions in letter and spirit;

v.    The quantum of penal charges will be reasonable and commensurate with the non-compliance of material terms and conditions of the loan contract. Further, it will not be discriminatory within a particular loan / product category;

vi.   The penal charges applicable to an individual borrower, in lieu of a loan sanctioned for purposes other than business, will not be higher than the penal charges applicable to a non-individual borrower for similar non-compliance of material terms and conditions;

vii.  Regulated entities will formulate a board approved policy on penal charges and/or similar charges; and

viii. The quantum and reason of penal charges must be clearly disclosed by regulated entities to the customers in the loan agreement and most important terms and conditions / Key Fact Statement. Additionally, the same will also be displayed on the regulated entity’s website under ‘interest rates and service charges’.

Effective Date and Applicability

i.    The aforesaid instructions will come into effect from January 1, 2024.

ii.   With regard to the existing loans, the switchover to the new regime will have to be ensured at the earlier of the next review or renewal date (after January 1, 2024) or June 30, 2024.

iii.  Credit Cards, External Commercial Borrowings, Trade Credits and Structured Obligations which are covered under product specific directions are excluded from the purview of these instructions.

Way Forward  

i.    Regulated entities will be required to revise their policy on penal charges and have the same approved by their board.

ii.   Regulated entities will also be required to revise their loan documents to align the same with the instructions set out above.

iii.  In light of the switchover post January 1, 2024, it is recommended that regulated entities amend and start using the new set of documents at the earliest, so as to facilitate an easier transition.

iv.   If the regulated entities are not implementing the new set of documents prior to January 1, 2024, it should be ensured that the policy documents have clauses that allow for ease of process in amendments. This would ensure that regulated entities are able to easily incorporate the change in their documents post January 1, 2024.

[1] Regulated Entities means all Commercial Banks, Primary (Urban) Co-operative Banks, Non-Banking Financial Companies (including Housing Finance Companies) and all Indian Financial Institutions