Fair Lending Practice – Penal Charges in Loan Accounts

Context: Reserve Bank has issued draft guidelines to the financial institutions to ensure reasonableness and transparency in disclosure of penal interest.

Need for guidelines on Penal charges

Penal interest/charges are levied by the lenders on borrowers in case of default. The intent of levying penal charges is essentially to inculcate a sense of credit discipline among borrowers through negative incentives and to ensure fair compensation to the lender. Penal charges are not meant to be used as a revenue enhancement tool over and above the contracted rate of interest. However, supervisory reviews by RBI had found that some entities were in fact charging excessive rates of penal interest, leading to hardship to the borrowers and disputes. 

                      In the backdrop of raising share of retail lending (Personal loan category had surged to 30% in FY 23, from just 19% eight years ago, making it the largest credit category) RBI felt the need for issuing guidelines on fair lending practices.

The draft guidelines are:

  • Penalty levied by the financial institutions 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. There shall be no capitalisation of penal charges, i.e., no further interest computed on such charges.
  • The interest rate charged on a loan given by a bank includes appropriate credit risk premium reflecting the credit risk profile of the borrower. So, if the credit risk profile of the borrower undergoes change, banks will be free to alter credit risk premium as per the contracted terms and conditions.
  • The quantum of penal charges shall be proportional to the defaults.
  • The penal charges levied on individual borrowers cannot be at a rate higher than a similar charge applicable to corporate borrowers.
  • The financial institutions shall ensure that there is a clearly laid down Board approved policy on penal charges.

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