The Reserve Bank of India (RBI) took a significant step on Friday to ensure fairness and transparency in the disclosure of penal interest by saying that the penalty should be a ‘charge’ instead of an ‘interest’ that will be compounded.
“Regulated entities (RE) must not compute further interest on such charges. However, this will not impact the normal procedures for compounding interest on loan accounts,” RBI said.
The central bank highlighted that many REs impose penal rates of interest, in addition to the applicable interest rates when borrowers defaults or in case of non-compliance with the terms of credit facility approval.
In the circular, RBI issued various instructions to lenders on the basis of a review of practices for penal interest, and charges on loans.
The circular states that penalty for non-compliance of material terms and conditions of loan contract by the borrower shall be treated as ‘penal charges’ and shall not be levied in the form of ‘penal interest’ that is added to the rate of interest charged on the advances.
The circular comes at a time when there has been many instances of lenders charging a penal rate of interest, over and above the applicable interest rates, in case of defaults.
“The idea is that a penalty encourages credit discipline, and the RBI wants to ensure the lenders use penalties only to that extent. This is a borrower-friendly move by the RBI,” Adhil Shetty, chief executive officer, BankBazaar.com
The lenders must formulate a board approved policy on penal charges or similar charges on loans. They shall not introduce any additional component to the rate of interest, the circular said.
The quantum of penal charges must be reasonable and commensurate with the noncompliance of the terms and conditions of loan contract.
Also, the penal charges that are sanctioned to individual borrowers, for purposes other than business, shall not be higher than the penal charges applicable to non-individual borrowers for similar non-compliance of material terms and conditions.
The quantum and reason for penal charges shall be clearly disclosed to the customers in the loan agreement, in addition to being displayed the website of regulated entities under interest rates and service charges.
Whenever reminders for non-compliance of material terms and conditions of loan are sent to borrowers, the applicable penal charges shall be communicated. Further, any instance of levy of penal charges and the reason thereof shall also be communicated.
These instructions will take effect on January 1. Lenders must ensure implementation of the instructions with respect to fresh loans availed, and renewed from the effective date.
RBI said that the switch-over to the new penal charges regime for existing loans shall be ensured on the next review or six months from the effective date of the circular, whichever is earlier.
Currently, banks asses the penal interest as a part of interest income which in turn, boosts their net interest margin.
Resurgent India Managing Director Jyoti Prakash Gadia noted that the revised guidelines will impact the net interest margin of banks as the penal charges will be assessed separately and not as a part of the interest.
But, the degree of impact will vary from bank to bank depending on the penal interest earned in the past as a part of their interest income.
“The impact of the circular is difficult to quantify that at this stage. There may be a negative impact on margins as the penalty cannot be charged with the interest rate,“ says Karthik Srinivasan, senior vice president, group head – financial sector ratings, ICRA.
At the same time, fee income will go up because that will come as charges. The overall impact will depend on how the charges will be structured,” Srinivasan added.