RBI Policy: Banks to levy penal charge, not interest, in case of loan default; all you need to know

Along with raising of repo rate by another 25 basis points to 6.5 percent on Wednesday, the Reserve Bank of India (RBI) released a set of additional measures at the culmination of its first monetary policy committee (MPC) meeting on Wednesday.

Among a number of things, one of the key RBI announcements seeks to curb the practice of imposing penal interest by banks in case of loan default by borrowers.

The regulator, says the RBI statement, carried out a number of supervisory reviews which showed a practice of levying excessive penal interest by banks and NBFCS, triggering customer grievances and disputes.

To curb this practice, this late payment penalty should be in the form of a ‘charge’, and not ‘interest’, says the statement.

Although banks are permitted to formulate policy for levying of penal interest subject to board’s approval, however, the levy of this charge should be fair and transparent.

“In terms of extant guidelines, Regulated Entities (REs) have the operational autonomy to formulate Board-approved policy for levy of penal interest on advances which shall be fair and transparent,” reads the RBI’s statement on development and regulatory policies released in the follow up of the first monetary policy committee (MPC) meet of this Calendar Year.

Deviating from agenda

Banks tend to impose additional interest over and above the rate of interest on loan in case borrowers skip one EMI or more. For example, when a bank charges an interest of 10 percent on a loan and the borrower happens to skip an EMI then the penal interest kicks in.

Let us suppose the penal interest is 12 percent per annum, then an additional interest (1% per month) will be levied and added to the EMI that already carries 10 percent interest.

The RBI guidelines state that the intent behind permitting ‘penalty’ was to inculcate a sense of credit discipline but it is, at times, used to improve revenue by the banks. The financial institutions, therefore, do not refrain from imposing exorbitant interest, even 2 to 2.5 percent every month, over and above of the prevailing rate of interest.

“Such charges are not meant to be used as a revenue enhancement tool over and above the contracted rate of interest,” reads the RBI statement.

The RBI statement also says that any penalty for delay and default in servicing of the loan by the borrower will be in the form of ‘penal charges’ in a reasonable and transparent manner and not in the form of ‘penal interest’ added to the rate of interest.

The statement also clarifies that the penal charges are meant to be recovered separately and not added to the principal.

The RBI will add draft guidelines to its website to seek comments from stakeholders.