Penal Charges and not penal interest

Penalty on loans: Not as interest but as charges

Wish it is available for COVID Restructured Loans also

On 8th February 2023, Reserve Bank of India (RBI) informed that in order to ensure reasonableness and transparency in disclosure of penalty levied in loan accounts and to prevent Regulated Entities (REs) from using penal interest/charges as a tool to enhance their revenues over and above the contracted rate of interest, the instructions in respect of penalty are being revised. Accordingly, it released a 'draft' circular on 12th April 2023, indicating the changes proposed in respect of 'penalty' levied in loan accounts and requesting for the comments of REs before 15th May 2023. The changes are sure to benefit the borrowers immensely.

Salient Features:

  • Rate of interest already includes appropriate credit risk premium reflecting the credit risk profile of the borrower. And if the credit risk profile undergoes a change, RE is always free to alter the credit risk premium.
  • Hence there is no need to levy penalty in the form of interest, which becomes part of loan outstanding. Penalty, if charged, for default/ non-compliance of material terms and conditions shall be in the form of charges only 
  • Penal charges shall not be capitalized. That is, it should not be added to the loan outstanding (since interest is applied on loan outstanding) and should be recovered separately. 
  • Penal charges shall be proportional to the default/non-compliance of terms and conditions and should be charged beyond a threshold/limit. While REs are free to determine the threshold, it shall not be discriminatory within a particular loan/product category.
  • Penal charges for individual borrowers shall not be higher than penalty charges applicable for non-individual borrowers
  • Penal charges should be disclosed as part of terms and conditions of sanction. It should always be communicated again, whenever reminders are sent for payment of interest/ instalments/ compliance of terms and conditions.
  • Board approved policy on penal charges on loans should be in place with due regard to regulatory prescriptions as above. 
  • Operationalization of 'penal charges' in place of 'penal interest' by the REs are subject to review of RBI during supervisory examination.

The changes in 'penalty' as charges and not as interest are not applicable to credit cards, which are covered under product specific directions.

Clarity Needed: In my view, the following aspects should also be addressed by RBI, without leaving it to the REs to be included in their Board approved policy, so as to bring about more transparency in fair lending practices.

1. Since the penal charges are levied separately, the period within which the same should be paid by the borrower should be mentioned. In case of delay beyond the period specified, whether any charges will get added to the penal charges levied. (Ideally, the borrower should be asked to pay the charges within 90 days, similar to the period fixed for identifying NPAs)

2. How many times the penal charges can be levied in respect of non-payment of instalment/interest within a year/tenure of a loan.

3. When the customer pays the money into his deposit/regular account for paying the loan dues, which shall be appropriated first - instalment or interest or penal charges? (It will be proper, if the appropriation is done in the chronological order of sequence of events)

The circular can be made effective on COVID Restructured Loans retrospectively: 
Case in Point - Car Loans: I had the privilege of interacting with many self-employed car owners operating passenger cars in franchise with Ola, Uber and other kind of travel agencies. Most of them were not operating their vehicles during COVID period and had less opportunities, at least for 6-12 months in the post COVID period. Some availed loans from PSBs, some from private banks and others from NBFCs. Though the government introduced ECLGS (emergency credit line guarantee scheme) to extend additional finance and RBI permitted the REs to restructure the loans, without applying the interest on interest clause for over dues, the car owners pleaded that they are unaware of any concessions extended and also said that the banks/NBFCs did not provide them with the details of the restructuring exercise, except the number of additional instalments to be paid on account of restructuring. From the conversations, I understood that a loan, with original repayment of three years, was extended to 3 year 9 months (EMI being the same amount),  a five year loan was extended to a six year - six year 6 months, etc. It appeared that on an average the repayment period was extended by 6 months to 18 months, depending on the balance outstanding at the time of restructuring. On further enquiries, I felt that the total interest amount (not the interest rate) paid in respect of a loan should have gone up at least by 20 per cent over the interest amount that might have been paid, had the loan been closed in time. Even after factoring in the extended period of repayment, the interest amount paid by the borrowers concerned (due to more number of EMIs), appeared on the high side. While I am not willing to make any guess on the interest rate charged, there is a possibility that penal interest clause might have kicked in, when the EMIs were not paid for a specified period of time. And this might have resulted in the number of instalments going up between 6-9 months for a three year loan and 12 - 18 months for a five year loan. 

Since the proposed changes are applicable to all REs, viz. Scheduled Commercial Banks, HFCs and NBFCs, will RBI consider to make the proposed changes in 'penal charges/ interest' applicable with retrospective effect at least for COVID restructured loans, especially for loans paid through EMIs?

Regards

V. Viswanathan

21st April 2023


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