Reserve Bank of India Introduces Penal Charges for Implementing Fair Lending Practices

Posted On - 13 June, 2024 • By - King Stubb & Kasiva

Introduction

The Reserve Bank of India (RBI) has recently issued various instructions to various banks and financial institutions, collectively called regulated entities to for ensuring that these entities do not capitalise upon the defaults being committed by the borrowers. According to the “Fair – Lending Practices – Penal Charges in Loan Accounts” which was notified by the Reserve Bank through its notifications in August, 2023 and December, 2023 [1] respectively; a protocol pertaining to the above provisions has been laid down which states that the banks and regulated financial institutions are mandated to adhere to the rules which mandate them to not capitalise the defaults committed by the borrowers.

Moreover, the entities to which the above instructions are applicable have also been listed in the notification which are as follows:

Entire chain of commercial banks which include regional rural banks, local area banks and small finance banks but exclude payment banks.
All urban primary co – operative banks.
Entire Non – Banking Financial Institutions (NBFCs) such as NABARD, SIDBI, NABFID Etc.
All – India Financial Institutions

Purpose of the Initiative

The Reserve Bank of India, through this initiative aims to ensure that even though the objective is to make sure that the mutually agreed and consented terms of the lending and credit facilities are agreed by both the parties, especially the borrowers; there have been various instances in the past wherein it has been evident that the regulated banking entities mentioned above have been using these penalties levied upon the borrowers as a source of regular revenue which has led to an increase in the borrower – lender disputes. Therefore, through these instructions and notification, it has been aimed that such unjust, unregulated and unwarranted levying of penalties which is above the agreed interest rates is eradicated or minimised to the most minuscule possible extent.

Secondly, it has also been observed in the recent past that majority of the lending institutions have been imposing penalties in form of interests upon the borrowers on default of payments and even on non – payments which was normatively intended to act as a negative covenant for borrowers to commit defaults. However, in financial records of these institutions the penalties upon the existing rates of interest are compounded as rates of interest which lead to lenders capitalising such amounts as their income from loan accounts leading to false inflation of profits.

In numerous instances, courts across jurisdictions in the country have laid down their observations upon the imposition of ‘penal charges’ and ‘penal interests’ and held that while the regular interests are applicable upon loans extended to borrowers in the normal course of business for generating revenue for the lending entities, penalties can be imposed only to deter or penalise the borrowers who have committed a default as a deterrent upon defaults on loans in the country. In the landmark case of Union of India V. Association of Unified Telecom Service Providers of India [2], it was noted that penal interests are different from the ordinary liability imposed upon a debtor on account of wrongs committed by him as a default on loans and it is not related to the damages that have been suffered. Therefore any such capitalisation of the penal interests is not only against the public policy but also the norms of financial institutions such as banks.

Keeping in mind the above guidelines and in order to fulfil the objective of deterring the regulated entities from capitalising the penal interest amounts, the RBI has also clarified that the regulated entities cannot impose any penal interest per se on default of payments supposed to be made but penal charges may be imposed which are expressly stipulated in the lending or borrowing agreements. Additionally, the applicable penal charges must also be communicated to the parties in advance and there should not be any undue or illegal modification in these charges which might hamper the borrowers interest or act in contravention of public policy. Lastly, such penal charges must be based upon the non – compliance of the loan agreements and should not be arbitrarily based upon ad – hoc or undisclosed terms. Lastly, such charges must not be discriminatorily imposed upon any particular category of loans.

Conclusion

The notification and guidelines issued by the Reserve Bank of India have acted as a guiding light for the regulated entities mentioned above engaged in lending and financing activities by bringing in a quantum of reasonableness in the activity as it has made the penal charges uniformly applicable across loans categories in similar categories. Secondly, the notification has also established a correlation between the charges to be levied as penalty and the quantum of breach along with making them uniform across all individual and non – individual borrowers and lastly, even though there has been a heavy criticism of the penal interests along with taking steps towards non – applicability of penal interests and its capitalisation, the notification has made sure that the deterrent impact upon the borrowers in form of penal charges is not abolished.

This notification has brought out a balance between the interests of the borrowers and lenders by not only preventing the capitalisation of penal interests but also discouraging the borrowers from defaulting upon their loans and thereby creating a balance between the rights of both the stakeholders and promotion of a healthily functioning economy in the country.

[1] https://rbi.org.in/Scripts/NotificationUser.aspx?Id=12585&Mode=0#:~:text=001/2023-24%20dated%20August,effect%20from%20January%201,%202024.

[2] https://indiankanoon.org/doc/77529842/

King Stubb & Kasiva,
Advocates & Attorneys

Click Here to Get in Touch