Chit funds need smarter,not tighter,regulation
The ongoing debate on the financial scandal involving the Saradha group in West Bengal has put the focus on chit funds,one of the oldest but still poorly understood financial institutions in India. To draw the right policy conclusions from the demise of the Saradha group,it becomes imperative that we address a few pertinent questions regarding the chit fund industry. It is important since the Saradha group was not an actual chit fund but a Ponzi scheme,which works differently. We base our discussion on a series of largescale and representative surveys we conducted with more than 2,000 chit fund customers in 2008 and 2009,as part of the report Chit Funds as an Innovative Access to Finance for Low Income Households.
Chit funds are indigenous financial institutions in India that cater primarily to the financial needs of low-income households,typically excluded from the formal financial system. It is a mechanism that combines credit and savings in a single scheme. A group of individuals (typically 20-30) come together on a monthly basis and contribute a pre-determined savings amount to a common pool. Every month,the members of the chit scheme can then bid to get the pool if they are in need of a loan. This way,people who are in need of funds will bid early and become borrowers from the fund and those who want to save will only bid at the end. The ingenuity of these schemes is that it allows people who have only limited access to formal financial institutions to pool their liquidity and allow for local savings and borrowing solutions.
From our surveys in the states with the largest chit fund participation (Andhra Pradesh,Delhi,Karnataka,Kerala and Tamil Nadu),we find that 70 per cent of the participants have income less than Rs 20,000 per month. In particular,32 per cent have monthly income of less than Rs 10,000. It is also interesting that more than 90 per cent have a regular savings bank account and 33 per cent have even taken a bank loan. So,while these participants are not completely excluded from the formal banking market,they choose to participate in chit funds since the formal banks are not satisfying their financial needs. In fact,chit clients come from a diverse set of backgrounds: 43 per cent are small self-employed business owners who participate in chits to fill their working capital requirements,23 per cent are non-government salaried employees,13 per cent are government salaried employees,and the rest housewives and retirees. These latter groups state they participate mainly to save,but they like to have the option to borrow from the chit in case of emergencies like medical expenses. Interestingly,more than 95 per cent of the chit clients who participated in our surveys perceive this industry and the specific fund they deal with to be safe.
To compute the industrys size,we collected data on all registered chit schemes in these states in 2007. Approximately Rs 11,200 crore was circulated via more than 2,000 chit schemes in Andhra and Tamil Nadu alone. We estimate that about 8 per cent of households there participate in the registered chit fund industry. However,our surveys also show that the size of the unregistered or illegal chit fund industry is 15 times larger than the registered industry.
Interestingly,the unregistered chit funds predominantly cater to lower income people who have lower chit values. Over the last decade,it appears that registered chit funds have steadily increased the value of their schemes,which has made it more difficult for poorer households to access the regulated industry. Subsequently,unregistered and unscrupulous chit fund operators increasingly serve them. This makes their hard-earned savings extremely vulnerable to fraud. This trend reflects the high cost of regulatory compliance,which is pushing registered chit companies to offer high value schemes while lower value schemes are increasingly offered by unregistered companies.
The Chit Fund Act of 1982 regulates the industry. However,the regulation is an example of how the wish to make chits extremely safe has had the unintended consequence of achieving exactly the opposite. For example,according to the act,the chit fund manager needs to deposit 100 per cent of the chit value with the Registrar of Chits prior to the commencement of the chit scheme. Moreover,chit fund companies are also required to submit documents related to bidding within three days after the date of auction. Rather than making the industry safer,this has pushed most companies,in particular those offering low value schemes to low-income households,into the unregulated sector. Additionally,the implementation of the act has been left to state governments. As a result,there is a great deal of variation in terms of implementation. This has led to a race to the bottom where even many registered companies are shopping around for registration in poorly regulated states. Of course,not all regulatory efforts have been bad. For example,imposing a cap of 40 per cent on bidding prevents people from paying extremely high interest rates and requiring chit fund companies to be audited by certified chartered accountants prevents them from misusing the funds. In conclusion,we do not need even tighter but smarter regulation of the chit fund industry.
Kapoor is assistant professor of economics,Indian School of Business. Schoar is Michael Koerner 49 Professor of Entrepreneurial Finance,MIT Sloan School of Management,US
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