Legislative Updates -

Fair lending practice - penal charges in loan accounts.

In a notification dated August 18, 2023, the Reserve Bank of India ("RBI") provided detailed guidelines for Regulated Entities ("REs") to encourage fairness and transparency in the assessment of and disclosure of penal interest and charges in loan accounts in the lending practises of financial institutions.

The key points are as follows-

1. The RBI has noticed that REs frequently charge punitive interest rates in addition to the appropriate interest rates when borrowers default or violate the terms of the loan.

2. REs are required to interact with borrowers openly and refrain from adding any extra elements to the interest rates. In accordance with the Guidelines, REs must also develop a board-approved policy on such criminal charges.

3. The distinction between "penal charges" and "penal interest" is made clear in the Guidelines. The borrower will be subject to 'punitive charges' rather than penal interest (i.e., interest added to the rate of interest charged on the loans) if they fail to comply with any important terms and conditions of the loan contract. Additionally, penalties are not to be capitalised, meaning that no additional interest may be added to such penalties.

4. According to the RBI, the routine process for compounding interest in the loan account would continue as usual.

5. According to the Guidelines, penalties for loans approved to "individual borrowers, for purposes other than business," should not be greater than those for identical violations of important terms and conditions that apply to non-person borrowers.

6. According to the Guidelines, in addition to being made public on the REs' websites, the amount and cause of penalty costs must be made very explicit to borrowers in the loan agreement or key fact statement, as appropriate.

7. The number of penalties levied by the REs must be reasonable, supported by the breach of significant terms and conditions of the loan contract. They must not be biased towards any particular loan type.

8. REs must inform borrowers of the appropriate punitive charges and the justification for them at the time that they are levied.

9. Credit cards, external commercial borrowings, trade credits, and structured obligations—all of which are governed by particular directives—will not be covered by these Guidelines.

10. Since these guidelines will be in force as of January 1, 2024, REs are recommended to update their frameworks and procedures to ensure that they are followed for any new or renewed loans after that date. The transition to the new system for current loans must be made no later than the next review or renewal date, or six (six) months after January 1, 2024, whichever comes first.

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