Origin of the banking and financial system is full of tales. Financial contracts are reported to be as old as written language. Economic historians sum up that writing appears to have been invented for the purposes of recording financial deals. Concept of every aspect of the financial system has its own story. Even as implementation of the concepts has undergone a sea change, the basic architecture of the functions of the banking system is intact even today. If Deposits and Loans & Advances form the pillars of this financial architecture, it is the Rate of Interest (RoI) which is the life line not only of the banking system but of the whole growth process taking place in the economic cycle. Remove this RoI component from the system, you won’t find depositors. Thus, leaving no scope to lend, which means money won’t multiply.
So, it’s the Rate of Interest that generates flow of money from sector to sector and place to place, ultimately resulting in economic development of societies, communities and geographies. Even as the element of interest has its own forms, this time it is the penal interest which has come into focus.
In the bi-monthly ’Statement on Developmental and Regulatory Policies’ released on February 8, the Reserve Bank of India (RBI) made a significant statement with regard to the levy of penal interest. The RBI said that penal interest on loan defaults will be replaced by penal charges. The draft guidelines on the issue are being released soon and these shall be placed on the RBI website for comments from stakeholders.
The RBI directions are in place which allows banks to levy penal interest, except in the case of priority sector loans, if the borrower defaults in repayment, non-submission of financial statements, etc. However, the banks were at the same time asked to have a board approved policy on penal interest which should be governed by well-accepted principles of transparency, fairness, incentive to service the debt and due regard to genuine difficulties of customers.
Levying of penal interest has been a bone of contention between borrowers and the banks. It has been a common source of complaints against the banks as the aggrieved borrowers have been knocking the door of the RBI. There is no uniformity in banks to levy penal interest on loans where there is default in the repayment. While scrutinizing the complaints the RBI disclosed that the reviews indicate there are diverging practices and there are excessive charges in some cases, leading to grievances and disputes. Now to address the growing unrest among borrowers on the issue of penal interest, the RBI soon after announcing the monetary policy disclosed that the central bank is trying to frame guidelines which will ensure that there is a transparent and uniform approach to this issue.
The announcement has invited focus of the stakeholders on the issue and the primary beneficiaries of the RBI intervention would be borrowers. Some experts were quick to react to the RBI intentions and said the proposal would affect banks and non-bank financiers with a higher share of self-employed and vulnerable customers. It will not make life any easier for banks using penal interest to their benefit.
What is penal interest and why do banks charge it?
The penal interest is actually a type of penalty levied by banks if a borrower fails to pay the loan installments as per the repayment schedule. The concept of the penal interest, having backing of the RBI, is actually to inculcate credit discipline among the borrowers.
In other words, penal Interest is an additional interest payable by the borrower/s at the rate over and above the interest rate fixed on the loan, as a penalty in case of any delay or default in the repayment of the loan. It is mentioned in the loan documents along with the percentage to be charged over and above the one agreed upon in the loan contract. Its calculation involves three parameters - penal interest rate, overdue amount and period of default.
The rate of penal interest is not uniform and varies from bank to bank. According to the reports, many cases are pending in courts and tribunals at the behest of banks where the borrowers have challenged the levy of excessive penal interest by bank on loans availed by them. This itself reflects the prevailing complexity of rules and regulations in this field.
Why has the RBI decided to do away with the penal interest when it has its backing?
As mentioned above, the concept of the penal interest was to instill credit discipline among borrowers. In a way, the penal interest clause mentioned in the loan documents is to serve as a constant reminder to the borrower about his commitments in repaying the loan. But the banks were blamed by the borrowers for misusing the penal interest clause and questioned its transparency.
Let me quote the RBI statement which it gave soon after announcing the monetary policy on February 8. “The supervisory review conducted by the RBI reveals that most banks use penal rate on top of the normal interest rate in terms of defaults and non-compliance terms and conditions of entities sanctioning the credit facilities. The intent of penal interest was essentially to inculcate a sense of credit discipline among borrowers through negative incentives but such charges are not meant to be used as a revenue enhancement tool over and above the contracted rate of interest.”
In order to maintain credit discipline among borrowers and curb the practice of misusing it by the lenders, the RBI has floated the idea of replacing penal interest with penal charges.
How would penal charges be different from penal interest?
While ‘penal interest’ is typically added to the rate of interest being charged on advances, ‘penal charges’ shall be recovered separately and shall not be added to the principal outstanding. For instance, in penal interest the banks do not refrain from imposing interest, even 2 to 2.5 percent every month, over and above the prevailing rate of interest once a borrower defaults in repayment commitment. Penal charges won’t be added to the principal amount outstanding and shall be recovered from the borrower separately.
Is it going to benefit borrowers?
Of course. The RBI’s decision may lower the burden of borrowers who default in repayment of the loan not intentionally but due to compulsion owing to business loss or financial crunch . At the same time it will not only enhance the credibility of the banks but will also strengthen the trust of borrowers.
It is fervently hoped that there will be clarity in the guidelines about the extent of penal charges that may be levied. Even, guidelines should include the circumstances under which they can be levied by the banks. Besides, the penal charges should continue to be a deterrent for the borrowers to not default.
Disclaimer: The views and opinions expressed in this article are the personal opinions of the author. The facts, analysis, assumptions and perspective appearing in the article do not reflect the views of GK.
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