The Reserve Bank of India’s recent draft circular on penal charges on loan accounts is a welcome move that should give respite to individual borrowers. The RBI has emphasised that it wants to ensure that lenders do not seek to unduly profit from borrowers’ defaults in servicing their loans even as it allows the credit provider to reprice the loan in case a borrower’s ‘credit risk profile’ has changed. The Central bank’s draft guidelines on ‘Fair Lending Practice’ are aimed at obviating a practice where lenders have hitherto levied a penal interest over and above the contracted rate of interest when borrowers delay repayment or default. Observing that the regulatory intent of a penal levy was solely to foster credit discipline among borrowers through a negative incentive, the RBI noted that lenders, however, had in practice turned the penal interest into a revenue enhancement tool. Supervisory reviews had found that some entities were in fact charging ‘excessive’ rates of penal interest, leading to hardship to the borrowers and disputes. Lenders had also, in certain cases, been capitalising the penal interest, thereby increasing the principal amount that the borrower would ultimately have to repay. The banking regulator has now emphatically laid down that penal charges should be recovered separately and must not be added either to the principal outstanding or the rate of interest charged on the loan. Lenders could, however, still follow the normal process for compounding the outstanding primary interest, it clarified.
The RBI’s decision to step in to ensure a fair and transparent approach to credit pricing has to be seen in the context of the sharp uptick in retail lending in recent years. While industry’s share of outstanding bank credit had shrunk to about 24% as of February 2023, from over 43% in 2014-15, the omnibus category of personal loans had surged to 30%, from just 19% eight years ago, making it the largest credit category. The central bank has made clear to lenders that while it gives them the freedom to set the quantum of penal charges proportional to the default or non-compliance with the terms of the loan contract beyond a preset threshold, the threshold itself should not be discriminatory within a specified loan or product category. And the penal charges so levied on individual borrowers cannot be at a rate higher than a similar charge applicable to corporate borrowers. Crucially, the penal charge must be communicated upfront when finalising every loan and unfailingly reiterated to the borrower in every subsequent reminder for loan repayments. Small borrowers are sure to heave a sigh of relief as the RBI has made clear it will not brook any usury.
