Chit funds are native financial institutions in India. The system caters to financial needs by combining processes of credit and saving in one scheme. The chit funds are Indian equivalent to Rotating Savings and Credit Associations (ROSCA). Commonly called as “Save and Borrow” schemes.
Chit funds are financial schemes which are limited to a group of people who come together on a mutual trust with planned need and usage of funds. These schemes are designed on the principles of
“No one stands to loose and all stands to gain”.
Chit funds act came into existence in 1982 as an enactment of government of India. Different chit funds operate in different ways; and there are also many fraudulent tactics practiced by many private firms. The basic necessity of conducting their operations is a group of needy people called subscribers. Foreman is the person responsible for collecting the money from subscribers, presiding the auctions and keeping records of subscribers.
One of the way, how these Chit Funds Work:
Assume 25 members team contributing to a chit value of Rs. 25,000 at Rs. 1000 per month for 25 months. The foreman conducts an auction meeting for a total amount of Rs. 25,000/- where bidders can bid by discounting with a maximum of 30% and minimum of 5%. Winning bidder gets Rs. 17,500/-. Discount amount is further divided amongst the 25 members after deducting foreman commission of 5%.
Saradha Group has been under intense media scrutiny in the last few weeks. The collapse of its public investment schemes, run under the façade of a collective investment scheme (CIS), which is regulated by the Securities and Exchange Board of India, caused severe losses to many people. There are various such financial schemes such as chit funds, multi-level marketing schemes or ponzi schemes which are all different from one another.
Unorganised chit funds
In simple terms, a chit fund is an arrangement that a group of people arrive at to contribute money in a defined manner at periodic intervals into a pool or a kitty. During the process of collection, any member can draw a lump sum through various ways like a lucky draw, an auction or a member can even fix a payout date based on a known expenditure.
The number of members equals the number of times a contribution is made to ensure everyone gets a turn. For example, if a group of say 15 people pay Rs.2,000 each a month, the total monthly pool becomesRs.30,000. Now, in case of an auction, if three members need money at the same time, one is chosen through a process of bidding and the lowest bidder gets the deal. So if three people put in their bids (the bid amount is usually slightly lower than the total pool amount) and the lowest bid is Rs.25,000, then the bidder will get Rs.25000 immediately; the remaining amount gets divided among the remaining members at the end of the tenor.
These schemes are very popular in tier II and III towns in India and even in rural India, thanks to under-penetration of banking services, as they are a way of raising quick money or catering for sudden liquidity needs or even a planned expenditure.
Organised chit funds
There are many organised companies incorporated to do this as a business and these are governed by state or central laws. There is a central Chit Funds Act of 1982, apart from a number of state chit fund Acts. There is an office of “registrar of chit funds” in every state that monitors operations which are quite stringent. Utilisation and appropriation of subscribers money is strictly prohibited.
While there are many companies, too, that have defrauded people, but there are genuine companies as well that cater to the cash requirements of members locally. The first step of regulation, therefore, comes at the state level; hence it’s the state government which is responsible for any fraudulent activities by chit fund companies. The issue arises because there is no entry barrier to start operations.
While a simple form of chit fund operates to fund the needs of members, it can get complicated when it enters the realm of things like getting members to fund real estate projects and so on. The bad experiences have left individuals in some areas more vigilant. Organised or otherwise, this is not an investment plan, rather it is a way of funding your big spending by ensuring you get a large amount on a certain date. The lump sum comes at a reasonable cost and provides high convenience as compared with say a bank loan. Chit funds remain an option for those outside formal finance, those with bank accounts can stay away.
Know more about Ponzi Schemes.