Corporate May 1, 2013
Over the last few days, chit funds have been renamed. They are now called "cheat funds". This has happened in the aftermath of the Saradha Chit Fund going bust in West Bengal. But as this writer explained yesterday, Saradha was not a chit fund at all.
Estimates suggest that chit funds have been around for more than 1,000 years. The world over they are typically referred to as Rotating Savings and Credit Associations. While the details might vary from one chit fund to another, there is a basic structure to a chit fund. And that is what makes it enduring.
Let's try and understand this in some detail. A chit fund admits a certain number of members, who contribute a fixed sum of money every month. The total amount that is accumulated from the contributions made by the members of the chit fund is referred to as the 'pot'.
In this example, let's say a chit fund admits 25 members. Each of these members contributes Rs 2,000 a month. The value of the pot every month is thus Rs 50,000 (25 x Rs 2,000). Members of the chit fund bid for the pot. The amounts the members bid for from the pot is referred to as the 'discount'. The member bidding the highest discount gets the pot minus the discount and an organiser fees that needs to be paid to the individual or the company running the chit fund.
If the highest discount for the first month in the example being considered is Rs 12,500. Other than this there is an organiser fees of 5 percent of the value of the pot. This amounts to Rs 2,500 (5 percent of Rs 50,000). Hence, the member who has bid the highest discount will get Rs 35,000 (Rs 50,000 - Rs 2,500 - Rs 12,500).
The highest discount bid becomes a profit for the chit fund. While it raises Rs 50,000, it needs to distribute only Rs 35,000. Of this the discount is Rs 12,500 and Rs 2,500 goes to the organiser of the chit fund.
The discount is distributed equally among the members of the chit fund and is referred to as dividend. In this case every member will get a dividend of Rs 500 (Rs 12,500/ 25). This amount need not be paid out and can be adjusted against the contribution of Rs 2,000 to be paid by members in the next month. This means members will have to contribute Rs 1,500 each in the next month. This is the basic structure of a chit fund.
Are chit funds modes of saving or modes of borrowing?
The answer is they are both. Typically those who enter a chit fund to borrow make high discount bids during the first few months. They are desperate for the money and want to ensure that they land up with the 'pot' sooner rather than later.
Mudit Kapoor and Antoinette Schoar explore this phenomenon in a research paper titled Chit Funds as an Innovative Access to Finance for Low-income Households. They consider a chit fund with 25 members where each member contributes Rs 2,000 per month. This is most common scheme, Kapoor and Schoar point out. As they write, "The most common scheme is the chit value of Rs 50,000 ($1,000) for the duration of 25 months...In the first five months, bidding amount is usually high with members most urgently in need of funds...bidding. Afterwards, bid amount tends to decrease overtime. Inversely, members' contribution will increase over time as the dividend amount decreases."
So a member who bids a discount of Rs 12,500 for a pot amounting to Rs 50,000 is very desperate for money. In a way the discount is the interest that the member of the chit fund is ready to pay to have access to a bulk amount. He does recover some of this discount in the dividends that he gets in the months to come.
As Kapoor and Schoar write: "Our analysis of the bidding data shows that the average loan interest rate ranges between none (when the member is a saver in the scheme and does not bid) up to 3.5 percent per month for a 25-month scheme. Usually the interest rate peaks when approximately 1/3rd to 1/4th of the tenure is over."
Typically during the last few months of a chit fund the highest discount comes close to zero. By then, the members who are still to get the pot are those who are in the chit fund to save money and thus they are in no hurry to get hold of the 'pot'. Given this the highest discount bids starts to fall in value over the tenure of the chit fund.
What kind of returns do chit funds give?
People who enter a chit fund to borrow money end up bidding for the pot with very high discounts. This ensures that they end up paying an 'effective' interest. These individuals do not make any return from the chit fund.
Those who enter a chit fund to save money end up making money. But their returns depend on the level of desperation of other members who have entered the chit fund to borrow money. The higher the discount bid, the greater is the return that people who are in the chit fund to save money make.
So the greater the number of borrowers in a chit fund, the higher is the return that savers usually tend to make. Having said that, it is difficult to predict the kind of returns to expect given that there are too many variables at play.
Chit funds tend to claim that an individual "who is a saving member up to the last instalments gets dividend which is comparatively higher than the interest that are accrued by way of Recurring Deposit Schemes." This can't be said for sure. If a chit fund is skewed and has significantly higher saving members than borrowers this might not turn out to be true given that members will not be in a hurry to get hold of the pot and thus will not bid high discounts for it. This will limit overall returns. Hence, members entering a chit fund to save money and earn returns cannot know for sure what kind of returns they will end up with unlike a recurring deposit.
What are the other risks of investing in a chit fund?
Chit funds need to be registered under the Chit Funds Act 1982 or under any of the acts promulgated by various state governments. Any chit fund which has a pot greater than Rs 100 needs to be registered. The trouble is that a lot of chit funds are not registered. Kapoor and Schoar estimate that "on average the size of unregistered Chit Funds is about 67 times the registered industry in Delhi and 3.1 times in Chennai. In the rural areas, the proportion of unregistered to registered Chit Funds might be much higher."
Another estimate made by Preethi Rao in a research paper titled Chit Funds - A Boon to the Small Enterprises suggests that there are around 6,000 unregistered chit funds in Hyderabad. A lot of these chit funds are run by fly-by-night kind of operators.
A registered chit fund needs to deposit 100 percent of the value of the 'pot' with the Registrar of Chits in the state prior to the commencement of the chit scheme. Due to this, in the first month of operation of a chit fund there is no auction. The pot is handed over to the organiser of the chit fund to compensate him for the money that he has to deposit with the Registrar of Chits.
Trouble erupts when this tradition spills over even into the domain of unregistered chit funds. The organiser of the scheme is allowed first access to the pot. In many cases, the organiser can just scoot after he has been handed over the money. People have been known to lose a lot of money in such cases. This is a big risk when it comes to putting money into a chit fund.
What if a member defaults?
Also there is the risk of members stopping their contributions once they have won the pot. The chances of this happening are higher in an unregistered chit fund. In a registered fund there are legal ways to address this option. "When members fail to make their contribution for any particular month, they are initially requested by oral correspondence to pay the dues. If this fails, a reminder is sent by mail and finally a legal notice is issued and a person is taken to court", writes Rao. But as we all know legal options take time in India.
The other risk is that a chit fund gives out the pot only to one person at a time. A person who needs the money immediately may not get it because another person has outbid him by offering a higher discount for access to the pot. Rao writes: "Where two members are equally in urgent need of the loan in any particular month, the chit manager may allow them to make compromises among themselves wherein they may divide the 'pot' equally between them. However, in such cases, one of them will be held liable directly to the group for the entire amount and the other would be liable to the former for his/her share of the loan."
Rig up the discount
It is also possible for the organiser of the chit fund to rig up the discount bid. This involves those close to the organiser of the chit fund bidding high discounts for access to the pot. This sets the bar high and leads to a member who is desperate to access the pot offering an even higher discount. This practice was rampant during the early years of India's independence. As The Economic Weekly pointed out in an article titled Legislation for Chit Funds published in its edition dated 5 May 1962: "A common modus operandi is for a number of representatives of the company to subscribe to a chit scries. At the auction, they bid high to raise the rate of discount. In one case, for instance, it was found that a chit valuing Rs 2,500 (i.e. the pot) was auctioned for as low as Rs 1,675. This way the promoters swell their commission which is a fixed percentage of dividends."
What this meant was that for a pot of Rs 2,500 a discount of Rs 1,675 was offered. To limit these kind of practices, the government has since introduced legislation which limits discount to 40 percent of the total value of the pot. "This bid-cap is administered to ensure that the bid does not rise uncontrollably leading to subsequent default by the bidder," write Kapoor and Schoar. While registered chit funds have to follow this regulation, there is no way of knowing what unregistered chit funds do about this.
How does the organiser of the chit fund make money?
An organiser of a chit fund makes money by charging fees of 5 percent of the total amount of the pot. That we have already seen. There is another less evident way in which he makes money. The highest bidder for the pot is not given the money immediately. "For instance, it is a common phenomenon for the loan to be disbursed a month after the auction date. This means that the chit manager will earn interest on the loan amount for a whole month. When this repeats for every scheme in force, a large quantity of money accumulates," writes Rao.
"To illustrate this, let us consider a chit scheme that has an auction on the 7th of January. The contributions will be collected on the 1st of January. Now, the prized subscriber at the auction will be provided with the loan amount or the 'pot' only after a month, i.e. on the 7th of February. The chit manager will earn the interest on the collected amount essentially from the 1st of January to the 7th of February," she adds.
Given this it is not surprising that some organisers of chit funds have become extremely rich.
To conclude, the points discussed above seem to suggest that those who have access to a bank account should stick to dealing with banks, rather than run after chit funds. The returns are fairly unpredictable for savers, the interest paid by borrowers is very high and there are too many things that can go wrong.
Vivek Kaul is a writer. He tweets @kaul_vivek
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