Batting for borrowers – Penal levy on loan defaulters should not be usurious

Source: The post is based on the article “Batting for borrowers – Penal levy on loan defaulters should not be usurious” published in The Hindu on 25th April 2023.

Syllabus: GS – 3: Indian Economy and issues relating to planning, mobilization, of resources, growth, development and employment.

Relevance: About penal levy on loan defaulters.

News: The Reserve Bank of India recently released the draft guidelines on ‘Fair Lending Practice’ as there is an increase in retail lending in recent years. The draft circular regulates penal charges on loan defaulters. 

What is the rationale behind regulating penal levy on loan defaulters?

The industry’s share of outstanding bank credit had shrunk to about 24% as of February 2023, from over 43% in 2014-15. The personal loans had surged to 30%, from just 19% eight years ago,

There are times when lenders have levied a penal interest over and above the contracted rate of interest when borrowers delay repayment or default. This is done despite the RBI allows the credit provider to reprice the loan in case a borrower’s ‘credit risk profile’ has changed.

Earlier, the penal levy was focused on solely fostering credit discipline among borrowers. But in practice, the penal interest turned into a revenue enhancement tool.

Such as a) Some entities were charging ‘excessive’ rates of penal interest, b) Lenders had been capitalising the penal interest, thereby increasing the principal amount that the borrower would ultimately have to repay.

Thereby, lenders seek an unduly profit from borrowers’ defaults. So, the RBI has issued a draft circular for regulating penal charges on loan accounts.

How did the RBI’s Fair Lending Practice aim to reduce the penal levy on loan defaulters?

-The penal charges should be recovered separately and must not be added either to the principal outstanding or the rate of interest charged on the loan.

-Lenders can follow the normal process for compounding the outstanding primary interest.

-Lenders have the freedom to set the quantum of penal charges proportional to the default or non-compliance with the terms of the loan contract beyond a preset threshold.

-The penal charges levied on individual borrowers cannot be at a rate higher than a similar charge applicable to corporate borrowers.

-The penal charges must be communicated upfront when finalising every loan and unfailingly reiterated to the borrower in every subsequent reminder for loan repayments.

Overall, the move will benefit small borrowers, individual borrowers, and others.