Turning into a tool for financial inclusion

Turning into a tool for financial inclusion

Chennai: If a group photo were to be taken of Indian financial institutions, one graying credit source that is likely to be elbowed out is the chit fund. Unlike its spunkier cousin microfinance, which is mollycoddled by private equity, venture capitalists and policy makers alike, chit funds seem unloved.

While microfinance loans have grown 10-fold over the last four years, registered chit funds have, amid rising costs, fallen behind on the back of regulations that cap margins at 5%. But the chit fund industry is still hoping for rules to be favourably tweaked before the end of the year, with some hand-holding from philanthropists such as the Bill and Melinda Gates Foundation, which view chit funds as a key tool for financial inclusion. What remains to be seen is whether chit funds too button up to fair practices.


Briefly, a chit fund is India’s version of what is known overseas as Rotating Savings and Credit Associations (Roscas), also referred to as “the poor man’s bank". As the name suggests, customers can save as well as borrow in such a scheme, where members make a fixed contribution every month for a maximum of 50 months.

Every 30 days, the member bidding the highest interest (capped at 40%) in a five-minute auction takes the sum. The interest left on the table reduces the next month’s contribution of participants, so even if a member doesn’t borrow, she gains interest.

“For segments that had no access to any financing at all, chit funds did play a key role," says Ravi Trivedy, executive director at the consulting firm KPMG Llp. “While financial regulators are keen on financial inclusion, they are also foxed about which set of norms to deploy for the chit fund industry. For now, they seem to not want anybody to be in that business."

The failed romance between policymakers and chit funds arises from a spate of scams in the 1990s, when investors lost a lot of money; the scams earned these instruments the nickname “cheat funds". These episodes spurred increased policing through reams of paperwork, stoking operational costs and squeezing profits.

As a result, several chit fund companies have begun to operate as unregistered—and, therefore, unregulated—entities, putting small investors in this space at even greater risk.

Credit alternatives such as microfinance—small loans not requiring collateral and largely offered to women—have grown to a 19,500 crore market as of March 2010, from merely 1,800 crore in 2006, according to the Micro Credit Rating International Ltd.

But microfinance’s rise has largely occurred in rural areas. Further, for loans higher than 50,000, chit funds remain the dominant choice. Moreover, low-income populations are keenly aware of likely economic shocks from illnesses and job losses, and chit funds fit the bill as a savings tool that earns interest and provides liquid loans during emergencies.

Thus, even as the percentage of families investing in chits dipped in 2006, the average annual household investments in these Roscas rose by more than 15% in both Andhra Pradesh and Tamil Nadu, according to a survey by the Institute for Financial Management and Research, or IFMR. One of the key reasons for the increasing value of chits is because they yield higher commissions in the face of rising costs.

“It is key to revise legislation to make sure it doesn’t impose such high transaction costs, because then chit funds move to higher and higher value chits and don’t serve the poor anymore," says Antoinette Schoar, professor of economics at the Massachusetts Institute of Technology. Schoar and Mudit Kapoor of the Indian School of Business (ISB) spearheaded the IFMR survey across Andhra Pradesh, Tamil Nadu, Karnataka, Kerala and Delhi.

In 2006, even though registered chit funds circulated nearly 12,000 crore, the study found that not only were companies moving away from unprofitable low-value chits, many were also cancelling registrations. As a result, the number of illegal chit funds in Delhi stood at 67 times the number of registered ones; in Tamil Nadu, unregistered funds accounted for triple the size of the regulated sector.

“The chit fund industry came under the regulator’s microscope early on," says Arun Duggal, chairman of Shriram Chits and Investments Pvt. Ltd, one of the largest registered chit fund companies in India, operating in Tamil Nadu, Andhra Pradesh, Karnataka and Maharashtra. “But state-level regulation makes for a shaky scene."

While the Reserve Bank of India has an advisory role, the central and state governments have largely called the shots through the Chit Fund Act of 1982, which was last modified a decade ago. In most states, chit fund firms need to make monthly trips to the registrar to file for permission to bring a chit group together and deposit 100% of any scheme amount with the registrar. But these norms don’t prevent personal references and previous dealings from overriding, say, secured lending and submission of adequate paperwork.

P. Selvakumar, who works at the airport in Chennai, bought his first home by bidding on a 5 lakh Shriram chit, for which he had to merely provide his salary slip and personal guarantors, saving the need for a security valued at the price of a loan. The situation is likely to be similar in unregistered chits, where there is no cap on interest and where rules for secured credit are not always observed.

Such practices are not just unlawful but also risky for other investors, and any changes to the Chit Fund Act should ensure that only credit-worthy participants enroll in chits.

“Better credit-scoring models are required in an industry that is large and anonymous," says Schoar. “One has to then ensure that the screening and regulation of an industry that largely works on people knowing each other has to be substituted with a more formal regulatory structure."

Why invest in an unregistered chit fund?

In late 2008, a consultancy called Centre of Gravity studied nearly 2,000 consumers in six Bangalore slums to check the financial pulse of 1,200 households. About 14% of the households belonged to the top 11,000-20,000-per-month income bracket, and 90% of those families had invested in unregistered chit funds.

“The key reason cited for contributions towards chits was the flexibility it offered," says Vijay Kumar Chidambaram of Centre of Gravity. “Most of them say they need to keep the money out of the house so that it doesn’t get spent. In a chit, they can get the money back when required. And if they don’t bid for it, they still get more than what they invested at the end of it."

Most of the sample population first kept savings at home, but the immediate second option was to put money into a chit, which even beat out gold as a savings and investment tool. Banks were seen as the last option. The study found that the top two income segments in slums invested anywhere between 20,000 and 1,50,000 a year in chits.

“They know that chits are a double-edged sword and have heard stories of operators running away with contributors’ money; but they have also seen neighbours benefit from it," says Chidambaram. “So they do their homework on the chit fund operator by checking his history and also making sure that he is someone who lives in their slum, so that they can catch hold of him if required."