New Delhi, Aug 18 (IANS): The Reserve Bank of India (RBI) on Friday said that banks cannot use penalties imposed on loan defaulters for raising funds.

The central bank has modified norms related to loan accounts to ensure this.

The RBI said banks must treat penalty for non-compliance as ‘penal charges’ and it should not be levied in the form of ‘penal interest’ that is added to the rate of interest charged on the advances.

There should not be capitalisation of penal charges, in other words, no further interest should be computed on such charges, the RBI said further.

It went on to add in a circular issued on Friday that this will not affect the normal procedures for compounding of interest in the loan account.

The directions were issued after observing that many banks use penal rates of interest, over and above the applicable interest rates, in case of defaults or non-compliance by the borrower with the terms on which credit facilities were sanctioned.

"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.

The RBI's observations are significant as customers have often complained about lack of transparency on the part of banks while imposing penal charges on customers.

"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 or product category," the RBI circular said.