The Reserve Bank of India (RBI) has issued a draft circular on penal charges levied by banks and non-banking financial companies (NBFCs) on loan accounts, aimed at bringing in transparency.

As per the proposal, regulated entities such as banks cannot levy charges in the form of penalty interest. They cannot introduce any additional component to rate of interest if a default has occurred or if the borrower is non-compliant with the terms and conditions of the loan contract, the RBI has said.

The central bank observed that banks are levying higher interest rates on defaulters, over and above the applicable interest rates, on terms of which credit facilities were initially sanctioned.

As per the draft guidelines, the quantum of charges levied should be proportional to the default beyond a threshold.

“The quantum of penal charges shall be proportional to defaults/non-compliance of material terms and conditions of loan contract beyond a threshold. This threshold is to be determined by the regulated entities and shall not be discriminatory within a particular loan/product category,” the draft norms said.

Regulated entities shall also disclose penalty charges and related conditions in the loan agreement.

A board-approved policy needs to be framed while levying penal charges, the RBI added, saying the central bank's final circular on the matter will state when all related instructions shall come into effect.

The RBI has said penal charges are not meant to be used as a revenue enhancement tool over and above the contracted rate of interest.

“…supervisory reviews have indicated divergent practices amongst the regulated entities with regard to levy of penal interest/charges leading to customer grievances and disputes,” the RBI said.

The regulator said default or non-compliance by the borrower should be treated as penal charges, and should 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, ie, no further interest computed on such charges,” the draft said.

The norms will not be applicable for credit cards, which are covered under product-specific directions. Banks and NBFCs have been allowed to change credit risk premium, if the risk profile of the borrower changes.

Feedback on the draft norms can be sent by May 15, 2023.

“These instructions shall come into effect from a date to be indicated in the final circular and regulated entities may carry out appropriate revisions in their policy framework and ensure implementation from the effective date,” the draft norms said. 

Morgan Stanley believes that the RBI’s proposal to discourage banks from capitalising on penal charges and additional interest loan defaults could potentially weigh on lenders' revenues going forward.

"We believe there could be some negative revenue impact for banks," Morgan Stanley analysts wrote in a research note.

"That said, it is difficult to assess the impact, given limited information available in the public domain."

Macquarie, however, believes that the overall impact of the RBI's regulations on revenues and profitability of lenders would be "minimal."

These punitive interest charges are not a significant part of banks' revenues, Macquarie said in a separate note.