How does a chit fund work? Operating a chit fund is not illegal. The concept is almost unique to India and till recently,when banks were rarer,it was the most acceptable way to get bulk cash for millions of households looking to finance a marriage or buy a house. For such families,chit funds are also an introduction to organised finance outside the family circle. A chit fund at the basic level is simple: members gather at periodic intervals to pool in their savings and a lottery determines who will get the pool. The winner drops out of the lottery but is obliged to keep on contributing to the pool as well as repay the sum at an agreed interest. The interest earned is divided among all members as their profit. Economists agree such funds play a vital role in supporting poor families. Micro-finance institutions use these to set up self-help groups. The initial capital often comes from the institution; the group rolls it over and adds to it over time. Do fraud schemes work on the same model? Pyramid schemes or prize chits borrow from elements of both chit funds and direct selling to mislead members. Direct selling of consumer goods by companies,too,is a legal business. Companies encourage individuals to become direct sellers,whom they provide their goods on credit or cash as inventory. The seller in turn recruits members to buy the goods periodically and sometimes to sell farther down the line. Countries set limits on how much inventory a company can offer a seller,and licensing requirements for becoming one. How do the cheats work? They have used a wide range of tricks,but all of them bank on three principles. First,unlike a legitimate chit fund or a thrift-and-credit society,they promise the members they will get rich quickly. Second,they play on the relative poverty and vulnerability of the target population. Third,they hold up the success of plain vanilla chit funds or direct selling schemes to trap the gullible into believing they have signed up for these. How does one spot a cheat? The surest sign is the high rate of return promised. In Bengal,the companies promised investors returns of at least 15 per cent when banks have struggled to give anything above 8 per cent. Pyramid schemes also insist that subscribers get new members. In some cases,they soften it by asking for an informal introduction to new members. But unlike a legal direct selling scheme,there is no sale or purchase of products. Along with the high return,that should warn the potential investor they will be fooled. What are these investments supposed to be in? To deflect the attention of regulators,these schemes often hold up promised investments from the funds in a range of projects that can be bizarre. In the mid-nineties,North India was flush with plans to invest in plantations. Promoters have also thought up investments from emu farms in Tamil Nadu to real estate. The promoters use the money raised to put into projects that have no relation to the purpose for which they were raised; even when invested in the promised segments,they could never generate the returns promised. Pyramid schemes need a regular dose of new investors to keep themselves solvent. To keep the scheme going,they need the fresh cash from new investors to pay off the older ones. Typically,then,the early entrants remain happy and spread the word about the soundness of the scheme. Trouble begins as the numbers of investors increases,which means more money is needed to make the repayment,and when the economy enters a downturn. The stream of fresh investors dwindles and the run on cash begins. How effective is the law against such schemes? The central governments Prize Chits and Money Circulation (Banning) Act,1978,has two flaws. The first is that the administrative power under the central Act lies with the state governments; at the Centre,the authority for policing the sector is diffuse. Again,the Act is administered by the department of financial services in the finance ministry,but the authority to promote direct selling is with the Ministry of Consumer Affairs. As a result,no entity in the central government has the mandate to keep out the rogues. For instance,since pyramid schemes run close to money laundering,the Enforcement Directorate shares some responsibility. Similarly,since there is the issue of raising of public deposits,RBI permission is required. And finally,as arms of these entities often tap equity or bond markets,SEBI too is involved. At the state level,it is the Directorate of Economic Offences that has the executive authority to use the police to carry out the raids. As a result,the promoters often shop for regulators and often succeed. What has states experience been like? Before the current scandal in West Bengal,many states have been hit at some stage. In May 2011,a rash of dubious direct selling companies emerged in Manipur,while in June Kerala saw a mushrooming of the same. In Rajasthan,gold was the bait that trapped investors,while Delhi was scarred by plantation schemes. In Uttar Pradesh,illegal bonds were used to lure investors,especially in the eastern districts. Most states have responded with here-and-now models but the best response has been from Kerala. The state government has not only set up a public sector company to guide chit fund operations but also passed a law for direct selling. This means an investor has simply to check up if a company is registered as a direct seller or not to make up her mind. West Bengal has no such option. It has been bombarded by the fraud companys registrations,such as under the Societies Act or under the Companies Act. Those registrations mean nothing but the state has no better alternative to fall back on. If well run,they cannot fail New Delhi: Legitimate chit fund companies few major groups remain in this business are upset that the Saradha Group is being described as a chit fund company. Any financial institution that fails is called a chit fund, says R Thyagarajan,chairman of the Rs-60,000-crore Shriram Group. Thyagarajan founded Shriram Chit Funds in 1974 and it is today the largest such entity in India. The annual auction turnover of Shrirams chit companies is over Rs 3,000 crore,the profits around Rs 25 crore. Well-run chit funds cannot fail. And they are not very profitable; the margins are wafer-thin, says Thyagarajan. Margadarsi Chit funds,promoted by Ramoji Rao in Andhra Pradesh in 1962,pioneered the concept in that state. It was the success of Margadarsi that inspired people such as Thyagarajan to set up chit fund companies. Ramoji Rao went on to build a huge business empire. Chit funds are the closest thing to a bank in many parts of India. They mobilise huge amounts of small savings and serve as micro-finance of sorts. In a properly run chit fund,it is not possible to delay monthly disbursements even if a few subscribers default. Shriram Chits,which has more than 30 lakh subscribers,has schemes involving monthly instalments as low as Rs 250. Of non-banking finance companies that collected deposits in the 80s and 90s,many have faded out or reinvented themselves. When the Rs-1,200-crore CRB Finance collapsed in 1996,RBI tightened regulations for collecting deposits. Crashes can happen after a company collects deposits privately,without being registered as either a chit fund or an NBFC. Invariably,when the funds get diverted to real estate and the stock market,and when crashes take place in these sectors,the depositors lose out. Sushila Ravindranath
