Concerned over the practice of banks and Non-Banking Financial Companies (NBFCs) using penal interest as a revenue enhancement tool, the Reserve Bank on Friday came out with modified norms, under which lenders would be able to levy only "reasonable" penal charges in case of default in repayment of loans.

The banks and other lending institutions will not be allowed to levy penal interest with effect from January 1, 2024, the RBI said in its notification on 'Fair Lending Practice-Penal Charges in Loan Accounts'.

"Penalty, if charged, for non-compliance of material terms and conditions of loan contract by the borrower shall be treated as 'penal charges' and shall not be levied in the form of 'penal interest' that is added to the rate of interest charged on the advances," RBI said in a notification.

It further said the quantum of penal charges "shall be reasonable and commensurate with the noncompliance" of material terms and conditions of loan contract without being discriminatory within a particular loan/product category.

Also, there shall be no capitalisation of penal charges -- no further interest computed on such charges.

However, the instructions will not apply to credit cards, external commercial borrowings, trade credits and structured obligations which are covered under product-specific directions, the RBI said.

The RBI said that many entities regulated by it use penal rates of interest, over and above the applicable interest rates, in case of defaults/non-compliance by the borrower.

"The intent of levying penal interest/charges is essentially to inculcate a sense of credit discipline and such charges are not meant to be used as a revenue enhancement tool over and above the contracted rate of interest," the Central bank said.

However, supervisory reviews have indicated divergent practices amongst the entities regulated by entities with regard to levy of penal interest/charges leading to customer grievances and disputes, it said, while issuing the modified norms.