Penal Charges — RBI’s Move Towards Implementation of Fair Lending Practices

Introduction

The Reserve Bank of India (RBI) has issued certain instructions to banks and financial institutions to ensure that lending institutions are prevented from capitalising on the defaults committed by a borrower. The “Fair Lending Practice — Penal Charges in Loan Accounts” was notified by the RBI vide Notification dated 18-08-2023, read with the Notification dated 29-12-2023, (collectively “Notifications”). These Notifications lay down the protocol that banks and financial institutions are required to follow with effect from 01-04-2024 in case of new loans, and not later than 30-06-2024 in case of existing loans (effective date). The RBI has further issued “frequently asked questions” on 15-01-2024 (FAQs) for better understanding and implementation of the Notifications.

The instructions apply to “regulated entities” (REs), namely:

(i) all commercial banks (including small finance banks, local area banks and regional rural banks) excluding payments banks;

(ii) all primary (urban) cooperative banks;

(iii) all non-banking finance companies (including housing finance companies); and

(iv) all India financial institutions [Exim Bank, National Bank for Agriculture and Rural Development, National Housing Board, Small Industries Development Bank of India (SIDBI) and National Bank for Financing Infrastructure and Development (NaBFID).

RBI’s objective

Most lending institutions impose penal interest on borrowers upon a payment default, and at times upon non-payment defaults. This is supposed to act as a deterrent against borrowers committing defaults. As penal interest is added to the existing standard rate of interest, the same gets calculated and compounded at the same frequency as the standard rate of interest. Therefore, lenders end up capitalising the amount generated in the form of penal interest and treat it as income earned on the loan account.

While the purpose of levying such penalty is to ensure that the borrower adheres to the mutually agreed terms of the credit facility, it has been observed that penalties are used as a means of enhancing the revenues of the lending institution. Over the years, this practice has led to multiple disputes between borrowers and lending institutions. The instructions seek to eradicate, or at least minimise such unjust levy of penal interest over and above the agreed rate of interest.

Courts in India have in several instances clarified their view on imposition of “penal charges” or “penal interest” (which terms have been used interchangeably), observing that while regular interest is applicable on the loan with the intention of generating revenue for the lending institution from the lending activity in the ordinary course of business, penalty can be imposed only to penalise the borrowers for committing a default and with the intention of causing deterrence in the minds of the borrowers. The Supreme Court of India has in Union of India v. Assn. of Unified Telecom Service Providers of India¹, and various other judgments observed that “penal interest is an extraordinary liability incurred by a debtor on account of him being a wrongdoer by having committed the wrong of not making the payment when it should have been made, in favour of the person wronged and it is neither related with nor limited to the damages suffered”². The Supreme Court has further observed that capitalisation of penal interest is against public policy as it goes beyond its character of being implemented as a means of deterrent³.

The instructions

Vide the Notifications the RBI has issued the following instructions to the REs:

(i) Penalty imposed on non-compliance of material terms of the loan by the borrower should be in the form of “penal charges”. Hence, REs cannot levy the said penalty in the form of “penal interest”, which is currently added to the applicable rate of interest applicable to the loan. Additionally, the REs should not compute further interest on the “penal charges” if the borrower fails to pay such “penal charges” as per agreed terms.

(ii) No additional component should be introduced in the applicable rate of interest for the loan.

(iii) The REs should formulate a board-approved policy on levying the penal charges.

(iv) REs should ensure that the quantum of penal charges is reasonable and based on the non-compliance with the material terms of the loan. Further, the penal charges should not be discriminatory within a particular loan/loan category.

(v) Penal charges applicable on loans availed by individual borrowers, for purposes other than business, should not be higher than the penal charges applicable to non-individual borrowers, for similar non-compliance.

(vi) The quantum and reason for penal charges should be disclosed to the borrower, in the loan agreement and most important terms & conditions/key facts statement (as applicable), in addition to the same being displayed on REs’ website under interest rates and services charges category.

(vii) REs should communicate the applicable penal charges to the borrowers (including impositions of penal charges along with reasons thereof) while sending them reminders for non-compliance of material terms.

(viii) Prior to the occurrence of the effective date, adequate policies have to be implemented by REs to ensure compliance with the Notifications.

However, it is imperative to mention that the instructions issued under the Notifications do not apply to credit cards, structured obligations, external commercial borrowings, and trade credits.

Through the FAQs, the RBI has provided the following clarifications:

(i) As a breach of material terms and conditions of loan would result in the levy of penal charges, such material terms and conditions must be defined by the REs in their credit policy, which may be framed separately for different categories of loans.

(ii) As regards compounding of interest, REs can continue to charge interest on unpaid interest (including unpaid equated monthly instalments) at the contracted rate of interest till the same is paid, but no such compounding can be done at the penal rate of interest.

Effect of the Notifications

As a result of the Notifications and subsequent amendments made to the applicable Master Directions and Circulars⁴, the standard rate of interest applicable on loans advanced by the REs will continue to get accrued and compounded, whilst the penal charges imposed on borrowers in case of occurrence of material breach will get accrued (if unpaid) on the defaulted amount only and not the entire outstanding amount. Hence, the penal charges will not be treated as additional interest over and above the standard rate of interest. The Notifications provides that the REs can continue to penalise the defaulting borrowers so long as there is no capitalisation of penal charges.

This Notifications has brought an element of reasonableness, by: (i) making penal charges uniform across similar loan categories granted by an RE; (ii) prescribing that the penal charges applicable to individual borrowers should not be higher than the penal charges applicable to non-individual borrowers; (iii) linking the penal charges to the gravity of the breach; and (iv) not taking away the deterrent of consequences owing to a default of the loan.