The Reserve Bank of India’s (RBI) statement of February 2023 on developmental and regulatory policies noted that RBI supervisory reviews found divergent practices among regulated entities (RE), excessive charging of penal interest, and resulting customer grievance. The statement also noted that penal interest is meant to inculcate credit discipline through “negative incentives” and is not intended as a “revenue enhancement tool”. The statement affirmed that while penal charges can be charged in a transparent and reasonable manner for any delay or default in loan servicing or non-compliance with material terms and conditions, no penal interest should be added to the agreed rate of interest. Such penal charges should be recovered separately and not added to the principal outstanding, and there should be no capitalisation of interest. REs should be free to alter the credit risk premium based on the risk profile of the borrower.
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Following the statement, the RBI in April 2023 released a draft circular on penal charges on loans for public comment. The draft is addressed to all commercial banks and non-banking financial companies (NBFCs). Having common directions for both banks and NBFCs is a good move, as it minimises regulatory arbitrage.
REs must put in place a board-approved policy on penal charges. Such charges, and how and when they are applied must be clearly disclosed to borrowers in the key fact statement of the loan agreement, under the terms and conditions. They must also be set out on REs’ websites under a specific section on interest rates and service charges. Reminders to borrowers must also point out applicable penal charges.
The draft circular prescribes principles that penal charges must be proportionate to the default or non-compliance with material terms and conditions. Thresholds for these have to be determined by REs, and must not discriminate within loan and product categories. Penal charges levied on loans for individual borrowers, other than loans for business purposes, must not be higher than penal charges applicable to non-individual borrowers.
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The draft circular stipulates that interest on a loan and any conditions for the reset of interest rates will be governed by the RBI’s directions and that REs cannot introduce additional factors for determining interest rates. The circular reiterates the RBI’s statement of February 2023 that while penal charges for loan default or non-compliance with material terms can be levied, no penal interest over or above the agreed interest rate can be charged. Again, there can be no capitalisation of penal charges. It is of interest that the draft circular notes that its prescription against capitalisation does not affect the compounding of interest. This should be clarified, as there is a thin line between capitalisation of interest and compounding. There are cases where compounding is achieved by simply adding to principal amounts.
The draft circular states that the rate of interest on a loan must include an “appropriate credit risk premium reflecting the credit risk profile of the borrower”. An RE will be free to alter the credit risk premium if the credit risk profile of the borrower changes. This prescription reflects the RBI’s stated intention that penal interest should be used as a credit discipline measure, not as a revenue enhancement tool. To implement this provision, REs will need to increase their effectiveness in monitoring loan accounts. That will allow them to change the interest rate because of changes to borrowers’ risk profiles, rather than see borrowers default and then charge default interest. This will have the effect of making the lender-borrower relationship more dynamic and more attuned to the performance of the borrower.
Issuing the draft circular is a good move and its contents reflect a general acknowledgement of the growing maturity of the financial sector, in which regulation and growth are in lock-step with customer protection. Implementing the draft circular will require REs to be more dynamic and proactive in their relationship with borrowers. This will need greater investment in monitoring systems. Rather than simply passing on this cost to borrowers, this could be the moment that REs’ financial technology and regulators’ customer protection requirements tie in to produce a cost-efficient model that will benefit all.
Sawant Singh and Aditya Bhargava are partners at Phoenix Legal.
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