Actionable Mandate: New Fair Lending Rules

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Mandala Law Offices

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Mandala Law office is a boutique firm with a client-first approach. The firm has experienced partners that offer strategic legal solutions to a diverse national and international clientele with focus areas in M&A, Private Equity, Corporate Advisory, BFSI, Data & Technology. The firm's core value is to build a sacred circle of trust with clients, functioning as their trusted advisors.
In order to ensure transparency in disclosure of penal charges and interest rates on loans, the Reserve Bank of India, vide its circular dated August 18, 2023, on Fair Lending Practice - Penal Charges in Loan Accounts...
India Finance and Banking
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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" / "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.

Actionable Mandate: New Fair Lending Rules

India Finance and Banking

Contributor

Mandala Law office is a boutique firm with a client-first approach. The firm has experienced partners that offer strategic legal solutions to a diverse national and international clientele with focus areas in M&A, Private Equity, Corporate Advisory, BFSI, Data & Technology. The firm's core value is to build a sacred circle of trust with clients, functioning as their trusted advisors.
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