Chit funds are among India’s oldest forms of banking. They offer a savings and borrowing mechanism to the many excluded from India’s formal financial system. Yet, they are often associated with scams ranging from the Saradha scam to the Rose Valley scam and many others.
Recent legislative changes, together with a handful of technology-based chit funds, are now aiming to give this age-old form of finance a newer, cleaner look. They believe it remains an important means of financial inclusion for the country and should be encouraged rather than shunned.
Chit funds are an important form of savings, said Shamika Ravi, director of research at Brookings India. While in principle there are several institutions catering to the low-income segment, chit funds enable people to save small amounts. “People are saving and accessing liquidity, so it is financial intermediation at its most basic which is why they should be encouraged,” Ravi said.
Chit funds essentially pool funds from a set of customers, who also then go on to borrow from the fund. Who gets to borrow, how much and at what cost is determined by a ‘chit’ system, as the name suggests. Those who manage the fund get a small fee. These funds are different from collective investment schemes, where money is pooled and invested outside. Here, the pooled money is only used to provide lumpsum payments to those who are part of the chit fund.
Chit funds in India apparently date back to the 19th century but were formally recognised in the 1960s. In 1982, the Chit Fund Act was passed to providing a broad set of rules under which these instruments can operate. Since then, little formal attention has been paid to the structure or governance of chit funds.
From ‘Chit Funds’ To ‘Fraternity Funds’
Two recent pieces of legislation have brought the focus back on chit funds.
In the recently concluded sessions of parliament, both houses cleared the Banning of Unregulated Deposit Schemes Bill, 2019, and the Chit Funds (Amendment) Bill, 2019.
The first bill introduced criminal provisions and gave investigative authorities additional powers to clamp down on unregulated entities collecting deposits from customers. While the chit fund amendments introduce some cosmetic and some structural changes.
The aggregate limits for chit funds have been raised. Funds which have less than four partners can now raise up to Rs 3 lakh compared to Rs 1 lakh earlier. Those with more than four partners can raise up to Rs 18 lakh compared to Rs 6 lakh earlier. The ‘foreman’, who is responsible for managing the fund can charge a commission of up to 7 percent of the chit fund amount compared to 5 percent earlier.
In addition, the amended Act allows registered chit funds to adopt new names, including “Fraternity Funds” or “Rotating Savings and Credit Institutions”, in order to distinguish themselves from unregulated entities.
Together, the two legislative changes were intended to give a fillip to the regulated chit fund business.
“Under the new Act, chit funds have been re-recognised as important players in the financial system and the government has made a distinction between us and ponzi schemes that pose as legitimate chit funds,” said TS Sivaramakrishnan, general secretary of the All India Association for Chit Funds.
According to data provided by the association, there are 45,000 registered chit fund companies, with an annual turnover of Rs 60,000 crore. However, the size of the unregulated chit fund segment is three times larger, the association estimates.
Sivaramakrishnan, who is also the managing director of The Balussery Benefit Chit Fund, believes the new rules will encourage legitimate chit funds to grow their business.
While chit funds are intended to serve the low-income segment, over time the low fee has prompted a shift towards larger value chit funds.
A December 2011 research paper, co-authored by Mudit Kapoor of the Indian Statistical Institute, found that there was a “general exodus of low value chit schemes” from the formal market, mainly because these players found it “less lucrative” to serve the low-income segment. As a result these customers were forced to tap informal sources and money lenders that charged exorbitant interest rates, it added.
“The change in the fee structure at least makes it economical for formal chit companies to offer low-value chits as at the margins it becomes profitable once again to serve these customers, ” Kapoor, associate professor of economics at Indian Statistical Institute, told BloombergQuint.
Roy John, vice president and business head at Muthoot Pappachan Chits, added that the revision in the fees and lending limits will help them serve different customer segments depending on their business needs, health or personal spending.
Tech Makes Inroads
Alongside a legislative overhaul, technology is playing a critical role in modernising the industry. Over the last two years, a number of fintech firms have partnered with established chit fund companies and state governments.
One such company is ChitMonks, which has partnered with the Telangana government to create a real-time platform for monitoring all the business activities of registered chit funds in the state, using blockchain technology. Since the platform tracks all the activity of the chit group on behalf of the state regulator and subscribers, “it has helped to address frauds", Pavan Adipuram, founder, ChitMonks, told BloombergQuint.
There are also digital chit companies like KyePot which work with licensed chit funds at the back-end. “The platform issues digital chits and conducts all the activities digitally including e-auctions. Therefore the subscriber has a complete view of how the funds are managed,” said Sidd Gandhi, founder, KyePot.
Another company, CredRight, has partnered with a few chit funds and provides subscribers with a loan against the of their chits based on a credit-score model it developed. “Not only does this provide chit fund subscribers with loans from formal lenders but it gives the chit fund managers a lot of data on their customers’ savings and repayment behavioral patterns,” said Neeraj Bansal, co-founder and chief executive officer at CredRight.
Technology may help add to the shine of the industry but, according to Kapoor, the underlying factors contributing to the success of a chit fund remain unchanged.
“Chit funds have the advantage of understanding the savings behavior and the ability of their customers to repay the loans. Technology certainly helps to collect and provide credible information, but at the end of the day the fundamentals of any chit fund is the repayment ability of customers and the costs of managing the fund,” he said.
Governance Issues Remain Unaddressed
The attempts to give the chit fund industry a new look has, however, left the all-important aspect of governance unaddressed.
The only significant governance change in the amended Act is that at least two subscribers of the chit fund should be present at every auction, through video-conferencing.
Over the years, several recommendations have been made over the years to improve the governance and transparency of chit funds.
As per the 21st report of the 16th Parliamentary Standing Committee on Finance, which was released on Dec. 3, 2015, some of the proposals include:
- A centralized database of chit funds across the country
- Strengthening state government laws for protecting depositors
- Creating an independent regulator that would monitor all chit fund schemes
- Administration and enforcement powers for the Reserve Bank of India and SEBI
- State Level Committees, headed by the chief secretary of the state alongside members of the Registrars of Companies, Income Tax, Enforcement Directorate and the Economic Offenses Wing of the state police.
- Purchasing deposit insurance
But these recommendations have not been included in the Chit Funds Amendment Act. The amendments have not solved the transparency and accountability issues for subscribers, said Adipuram of ChitMonks.
“For example, the Chit Funds Act says that the money collected by a fund has to be distributed within 30 days from date of the chits’ maturity, and if it is not distributed then it has to be placed in a separate escrow account. But many companies would delay repayments and manipulate the physical records to show that they paid in time,” he said.
Suggestions to bring chit funds under a financial sector regulator have also not been addressed. According to Kapoor, any change in law involves the politics of give and take. “There has always been a question mark over who should regulate the chit funds, whether it should be the RBI or state governments. It becomes a political-economy issue,” he said.
Others believe what is needed is not new regulation but better enforcement.
“If there is malpractice or frauds it is up to individual state regulators to enforce these. The state authorities need to be strengthened rather than adding more regulations on companies that are already over-regulated,” said Manoj Padmanabhan, chief executive officer, Mayavaram Financial Chit Corporation Ltd.
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