Pre-payment penalty: RBI proposes, will banks size up?

FP Editors Sep 7, 2011

Pre-payment penalty: RBI proposes, will banks size up?

FP Editors Sep 7, 2011




In a move that is likely to cheer borrowers immensely, banks have been asked to do away with the pre-payment penalty clause on floating-rate loans. However, it still remains to be seen how banks choose to implement the proposal of the Reserve Bank of India (RBI).

The recommendation is one from the 10-point action plan suggested by the RBI to improve customer service in the banking industry, all of which were outlined in a press release issued after the Banking Ombudsman conference on Tuesday. Among the key recommendations was that banks must stop enforcing pre-penalty clauses on customers seeking an early end to their indebtednesss. “Banks must not recover pre-payment charges on floating rate loans. Floating rate loans pass on the interest rate risk from banks, which are much better placed to manage these. Banks only substitute interest rate risks with potential credit risks,” the release said.

Currently, when customers seek an early end to their floating-rate loans, they typically have to pay a penalty charge of as high as 3-5 percent of their outstanding loan amounts. This was done by banks to avoid asset-liability mismatches arising out of creating long-term assets (loans) against short-term liabilities (deposits). The penalty was also applicable on customers seeking to shift their loans from one bank to another if they found a better deal.

In addition, the central bank called on banks to offer long-term fixed-rate housing loans to customers and address their asset-liability mismatch issues by turning to the Interest Rate Swaps market. However, banks can charge pre-payment penalties in the case of fixed-rate loans, it added.

Retail loans are very often priced on floating rates. According to one media report, at least 80 percent of outstanding home loans in India are floating rate loans. The pre-payment penalty clause has long been a target for criticism from consumer groups and the banking regulator. Last year, a committee headed by M Damodaran, former chairman of the Securities and Exchange Board of India, recommended a ban on the practice. “Banks should not impose exorbitant penal rates towards foreclosure of home loans and a policy should be devised to ensure that the customer is not denied the opportunity to enhance his economic welfare by making choices such as switching to other banks/financial entities to enjoy the benefits conferred by market competition,” the Damodaran committee said in a report made public in August.

Similarly, a report by the Competition Commission of India (CCI) earlier this year favoured scrapping foreclosure charges on housing loans. Levying such charges was both anti-consumer and anti-competitive, the report had noted.

Another important recommendation from the Ombudsman conference was that banks would need to prove that they are not at fault in disputes over automated teller machines, or ATMs, and Internet transactions. Regarding failed ATM transactions, the onus will now be on banks to prove the customer’s negligence or fault. The customer must also be compensated for losses from unauthorised transactions. The regulator is also seized with the idea of providing insurance of some reasonable amount on customers’ credit and debit card transactions.

The RBI introduced the banking ombudsman programme for quick and inexpensive redressal of customer grievances in 1995.

While the recommendations are not formal directives as yet, according to The Business Line newspaper, the RBI is believed to have told the bankers present at the conference that the onus is on them to implement the suggestions, failing which the central bank would issue guidelines. According to one official from a state-run bank, the boards of individual banks will now have to take a decision on how to implement these suggestions, particularly the waiving of the pre-payment penalty clause.

In a related development, the Reserve Bank of India also said teaser loans — loans that have fixed interest rates in the initial years and offer floating rates later — would attract higher provisioning.

India’s largest private sector bank, ICICI Bank, introduced two home loan products, with interest rates fixed for one and two years, respectively. The country’s largest mortgage finance company, HDFC, followed suit, which announced a dual-rate scheme on Monday, offering home loans at a fixed rate for the initial three or five years and at a floating rate thereafter.