Some chit chat

Chit funds alone attract millions of investors. It is estimated that registered chit funds have collected Rs 300 billion worth of deposits. The real story apparently lies in unregistered funds,who,it is estimated,have collected Rs 30 trillion. This is nearly half of the Rs 64.8 trillion held in commercial banks (in February 2013). But while all chit funds may not be fraudulent,the danger of some being so,given the weaknesses in regulation,is very high.

The origins of India’s unregulated financial system lie in the poor and outdated financial regulatory system that India has clung on to. The banking regulator is proud of the fact that there have been no bank failures,no complex derivatives and the banking system survived the global crisis — a system,it claims,that offers an example for the world to learn from. The sad reality is,however,that as much as half the Indian population does not have access to this banking system. Even those who have access often find it unattractive. Interest rates paid to depositors have been pushed down through years of policies of administered interest rates and lack of competition in banking. Regulatory requirements for priority sector lending and holding of government bonds have further resulted in lower returns. The result is low or negative real interest rates for depositors.

This is fertile ground for unscrupulous individuals. A Ponzi scheme like Saradha can be set up. The law does not require all financial service providers to register with any single regulator. If a firm says it is a collective investment scheme,it is required to register with SEBI and be regulated by it. If it claims to be a chit fund,it is regulated by state governments. If it says it is a private company taking deposits for its business,it must be regulated by the registrar of companies as Sahara has claimed it should be. If it takes public deposits,it should register as a non-banking financial company and be regulated by the RBI. It may actually register with no one,as Saradha didn’t.

If any one regulator finds out a company is guilty of fraudulent practices and tries to stop its activities,it has to approach other regulators. The financial firm,in the meanwhile,can go to court,claiming the regulator has no jurisdiction over it,as in the case of Sahara. It can continue to collect money. The regulator has to prove in a court of law that the firm was indulging in activity that is under its jurisdiction,and then,during the long delays in courts,watch helplessly as thousands more get duped by the firm. Section 11AA of the SEBI Act,under which SEBI has been acting,defines “collective investment schemes” in terms of principles that identify such schemes. It,however,includes exemptions for institutions such as chit funds,nidhis and cooperative societies.

Will passing a more stringent law,as the West Bengal legislature has done,solve the problem? Do state governments have the capacity to regulate financial firms? Even if some well-governed state governments are able to regulate chit funds,the regulatory capacity of other state governments can be quite limited. Perhaps the way forward should be that state governments with weak regulatory capacity choose to hand over powers of such regulation to the Centre.

But even after that is done,institution-based regulation would continue to provide legal cracks in the system for unscrupulous firms to slip through. To address this issue,the Indian Financial Code (IFC),proposed by the Financial Sector Legislative Reforms Commission,suggests that the definitions of financial products and services be broad and principle-based,with no statutory exemptions. All kinds of deposit-taking and investment schemes,including chit funds,are covered by the proposed definitions. For example,a deposit,in the draft law,is defined as a contribution of money,made other than for the purpose of acquiring a security,which may be repayable at the demand of the contributor. As a consequence,anyone in the business of accepting deposits or managing investment schemes would need to get authorisation from the regulator. The IFC proposes two regulators. Under the proposed law,either a financial firm must obtain a bank licence from the RBI,or it must register with the Unified Financial Agency (UFA),the regulator of all financial firms and activities other than banking. This would eliminate the legal tussles over jurisdiction seen today. In addition,the IFC proposes powers of investigation and prosecution for the financial regulators to prevent further fraud.

But it is not sufficient to give regulators the powers to catch criminals. The origin of the problem,that is,the inaccessible and unattractive formal financial system,also needs to be addressed. Today,regulators have an incentive to ensure there is no failure of the financial firms they regulate,leading to over-regulation. Saradha depositors may be paid by a West Bengal tax on cigarettes,and SEBI may be given additional powers to prosecute. But beyond this legal patchwork,India needs a comprehensive legal framework for financial regulation if it is to protect investors and reduce such fraud in future.

The writer,professor at the National Institute of Public Finance and Policy,Delhi,is a consulting editor for ‘The Indian Express’

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