Fair Lending Practice - Penal Charges in Loan Accounts

Concerned over the practice of banks and Non-Banking Financial Companies (NBFCs) using penal interest as a revenue enhancement tool, the Reserve Bank of India (RBI) came out with modified norms.

About the guidelines

Background: The RBI has observed that many Regulated Entities (REs) apply penal rates of interest, exceeding the applicable interest rates, in the event of defaults or non-compliance by the borrower with the terms on which credit facilities were sanctioned.
The instructions in the guidelines shall come into effect from January 1, 2024.
Source of power to issue the guidelines by RBI:
- The instructions are issued under different sections of the Banking Regulation Act, 1949, the Reserve Bank of India Act, 1934, and the National Housing Bank Act, 1987 and shall be updated in the relevant Master Directions / Master Circulars of the applicable REs.

Other Highlights of the Modified Norms:

Levying penal interest or charges is intended to guarantee that the lender is fairly compensated as well as to instill a sense of credit discipline in borrowers through disincentives.
The new guidelines are applicable to banks, including small finance banks, regional rural banks, but excluding payments banks, NBFCs, All India Financial Institutions such as Exim Bank, NABARD, SIDBI and NaBFID, etc.
Lenders will have to formulate a board approved policy on penal charges or similar charges on loans.
In the case of existing loans, the switchover to new penal charges regime shall be ensured on next review or renewal date or six months from the effective date of this circular, whichever is earlier.
The modified norms will not apply to credit cards, external commercial borrowings, trade credits and structured obligations which are covered under product specific directions.

Impact on Consumers:

Supervisory reviews have indicated divergent practices amongst the REs with regard to levy of penal interest/charges leading to customer grievances and disputes.
Now, REs will have to disclose the quantum and reason for penal charges clearly to the customers in the loan agreement and most important terms and conditions/Key Fact Statement (KFS).
These will also be displayed on the website of REs under interest rates and service charges section.

MCQs based on the information provided in the blog

Question 1: What is the main concern addressed by the Reserve Bank of India (RBI) in the modified norms?

a) Increasing interest rates for borrowers
b) Decreasing credit discipline among lenders
c) Use of penal interest as a revenue enhancement tool
d) Overemphasis on small finance banks

Question 2: When do the instructions in the modified guidelines issued by RBI come into effect?

a) January 1, 2022
b) January 1, 2023
c) January 1, 2024
d) January 1, 2025

Question 3: Which of the following entities are excluded from the application of the modified norms?

a) Payments banks
b) NBFCs
c) Exim Bank
d) Regional Rural Banks

Question 4: What is the purpose of levying penal interest or charges, as mentioned in the modified norms?

a) To discourage lenders from offering credit facilities
b) To provide additional revenue to the government
c) To fairly compensate lenders and promote credit discipline
d) To encourage borrowers to default on their loans

Question 5: How will the modified norms impact consumers?

a) It will lower interest rates on loans
b) It will provide more flexibility in loan repayments
c) It will make loan agreements more complex
d) It will lead to clearer disclosure of penal charges and reasons in loan agreements