Actionable Mandate: New Fair Lending Rules – Financial Services

In order to ensure transparency in disclosure of penal charges
and interest rates on loans, the Reserve Bank of India
(“RBI“), vide its circular dated August
18, 2023, on Fair Lending Practice – Penal Charges in Loan
Accounts, issued instructions to lending institutions
regarding the imposition of penal interest and charges on financial
products and / or any other kind of financial assistance
(“Guidelines“). The Guidelines have also
led to amendments in several Master Directions and Master Circulars
issued by RBI to Regulated Entities.¹ These Guidelines
were initially scheduled to take effect from January 1, 2024.
However, this timeline was extended to April 1, 2024, for fresh
loans granted. For existing loans, penal charges must be
implemented at a review or renewal of the loan falling on or after
April 1, 2024, but no later than June 30, 2024
(“Effective Date“).

Applicability: The Guidelines are applicable to
all Commercial Banks (including Small Finance Banks, Local Area
Banks, and Regional Rural Banks, excluding Payments Banks), Primary
(Urban) Co-operative Banks, NBFCs (including HFCs), and India
Financial Institutions (EXIM Bank, NABARD, NHB, SIDBI, and NaBFID)
(“Regulated Entities“http://www.mondaq.com/”REs“). While the Guidelines govern
Regulated Entities, there are exemptions at product level for
Credit Cards, External Commercial Borrowings, Trade Credits, and
Structured Obligations, as they are governed by specific
instructions tailored to each product.

Change in Regime: Based on the granular
principles set forth in the RBI Guidelines, along with the FAQs
dated January 15, 2024, on Fair Lending Practice- Penal Charges
in Loan Account, it has become imperative to understand what
can be levied in the form of interest versus a charge. The
distinction between the two is not a simple change in nomenclature;
there is a difference in accounting treatment and methodology.
Penal interest involves compounding and is imposed as an additional
levy over and above the contracted / agreed upon rate of
interest.

Regulated Entities cannot impose penalties / fines on its
customers for failure to adhere to material terms and conditions of
the loan in the form of penal interest. The form of levy of penalty
has been changed to penal charges. The regulator has expressed its
intent through granular aspects by laying down:

1. breach of material terms and conditions of loan must be based
   on individual assessments;




2. the levy of charges must be reasonable and commensurate with
   the level of non-compliance of the material terms and conditions of
   the loan;




3. additional penal charges cannot be levied due to non-payment of
   penal charges.

The instances that trigger a penal charge are simple: material
breach of terms and conditions of the loan. The regulator has
granted the liberty of framing circumstances / events of breach,
materiality or degree of breach, and the penal charge that can be
levied for such breach. Such levies are, however, subject to
principles of parity and transparency, as is the intent of fair
lending;

1. Penal charges cannot vary depending on the customer’s
   constitution (individual / company /partnership / trust / HUF /
   society);




2. Penal charges within a specific product category may differ
   depending on the loan amount, provided it is approved by the board
   and is deemed reasonable or commensurate with the
   non-compliance;




3. Penal charges for loans sanctioned to individual customers, for
   purposes other than business, should not exceed those applicable to
   non-individual customers for similar non-compliance of terms.

RBI’s intent of restricting interest on interest by
doing away with penal interest is rather clear and unambiguous. In
its clear intention in doing so, the RBI has also expressed that
when a customer is in default, a Regulated Entity is permitted to
continue charging the contracted rate of interest on the entire
outstanding of the loan. The outstanding amount, therefore, is an
accumulation of the rate of interest plus (+) penal charge
only; capitalizing through penal interest on the principal and
interest is estopped from the Effective Date.

Key compliance: The Guidelines, enlist
additional to-do’s:

1. Board Approved Policy: Formulate a
   board-approved policy on penal charges or similar charges on loans
   that is reasonable and fairly relative to the severity of the
   breach of the terms and conditions of the loan, outlining the
   criteria for the imposition of such penal charges.




2. Disclosures: An explicit disclosure of penal
   charges is to be made upfront to the customer while granting a
   loan. Through the Most Important Terms & Conditions (MITC) /
   Key Fact Statement(KFS) where applicable, along with
   disclosures on the Regulated Entities’ website under the
   ‘interest rates and service charges’ section.




3. Communications: In the event, reminders are
   sent to customers for non-compliance / violation /breach of terms
   of the loan, Regulated Entities are also required to send the penal
   charges levied with such breach and specify reasons / instances for
   levying the charges.




4. Income recognition: As per RBI Master Circular
   on Prudential norms on Income Recognition, Asset Classification,
   and Provisioning pertaining to Advances dated April 1, 2023, any
   fees, commission, and similar income in regard to NPAs that have
   accrued should cease to accrue in the current period and should be
   reversed with respect to past periods, if uncollected. Accordingly,
   in respect of NPA accounts, penal charges shall be reversed to the
   extent it remains uncollected for the specific purpose of
   non-recognition of income. However, the same shall continue to be
   part of the total liability of the customer to the lender, unless
   waived as per the lender’s board-approved policy.

The nature of a penalty in any form is intended for a deterrent
effect. For a financial institution, in particular, the intent was
to ease efforts on account of recoveries / collection of unpaid
dues and instil credit discipline. The forthcoming financial year
will give us a deeper insight to the change in credit behaviour,
disruption at portfolio levels, and needless to say the revenue
impact on income and margins of Regulated Entities.

Footnote

1. Master Direction – Reserve Bank of India
(Interest Rate on Advances) Directions, 2016 dated March 03,
2016; Master Direction – Non-Banking Financial Company
– Housing Finance Company (Reserve Bank) Directions, 2021
dated February 17, 2021; Master Circular – Management of Advances –
UCBs dated July 25, 2023; Master Circular –Customer Service in Banks
dated July 1, 2015; Master Circular – Loans and Advances – Statutory
and Other Restrictions dated July 1, 2015.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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