Report of the Key Advisory Group On the Chit Fund Companies

The Government constituted a Key Advisory Group on Chit Fund / Nidhi Companies vide Order dated 30.09.2011. The constitution and terms of reference of the Group are in ANNEX. The Group had representation from all the stakeholders from the sector including the the Reserve Bank of India (RBI),  ISRAC,the Indian Banks' Association (IBA), PHDCCI, CII; Ernst & Young, prominent Law firms viz. Amarchand Mangaldas, Juris Corp; ISB Hyderabad, AIACF (a representative body of Chit Fund companies), Various State Government Representatives and also from some prominent Chit Fund Companies, with the following Terms of Reference:–

-Review of existing legal / regulatory / institutional framework for Chit Fund /Nidhi Companies and its efficacy;

-Action plan including policy initiatives for orderly growth of the Sector;

-To recommend the legal / institutional / regulatory initiatives related measures required for orderly growth of the Sector.

 2. After detailed deliberations a core Committee was formed under the Chairmanship of the PHDCCI representative. The committee after a few round of meetings submitted  a draft Report  which was circulated among the KAG members, discussed with the stakeholders, and has been modified taking into consideration the views expressed by the stakeholders. .A final Report of the Group has been finalized after extensive deliberations and consultation on a wide range of issues having a bearing on orderly growth of the sector.

 
I.  Consultation paper on Chit Funds

1.1 What is a chit fund?

Chit fund is a traditional financial system which was prevalent even before the evolution of Banking.  Though the system exists in other parts of the world by the name Rotating Savings and Credit Association (ROSCA), India is the only country where its operations are governed by legislations. Chit funds are classified as Miscellaneous Non banking Financial Institutions, under the Reserve Bank of India Act, 1934 and are now governed by Chit Fund Act 1982 which is administered by the respective State governments. This system with numerous in built advantages viz. tax free dividend, easy accessibility, user friendly services etc; and free of latent cost and periodic interest hikes, or pre closure charges, is the most preferred option, for those who plan to save small amounts. Chit fund is a saving cum borrowing instrument, which is unique when compared to other financial products.

The uniqueness of this industry over other financial intermediaries is the ability of the chit operators to evaluate the intrinsic strength of potential clients mainly on the faith of the subscribers’ ability to repay, a succor to lower / middle income group, small business man etc who are often wedged between the exorbitant cost of the money lenders and the stringent procedure of the bank.  The chit is also seen not merely as an investment but a drop-by-drop plan to get lump sum finance for marriage, education, housing, business etc, at a future date. The chit funds are of a self-liquidating nature and partake the character of Mutual Benefit.

1.2 How do they work?

A chit scheme generally has a predetermined value and duration. Each scheme admits a particular number of members (generally equal to the duration of the scheme), who contribute a certain sum of money every month (or everyday) to the ‘pot’. The ‘pot’ is then auctioned out every month. The highest bidder (also known as the prized subscriber) wins the ‘pot’ for that month. The bid amount is also called the ‘discount’ and the prized subscriber wins the sum of money equal to the chit value less the discount and the fixed fee to the foreman. The discount money is then distributed among the rest of the members (or the non-prized subscribers) as ‘dividend’ and in the subsequent month, the required contribution is brought down by the amount of dividend.

To illustrate the above, let us consider an example of a chit scheme with the following characteristics. Chit Value = Rupees Rs.5,00,000, Duration = 50 months and Members = 50. The contribution in this case would be initially Rs.10000 per month per member. In the first month, the collection would, therefore, be Rs.10000 multiplied by the number of members i.e. Rs.5,00,000. This amount is called the ‘pot’ which is auctioned out at the end of the month. Now let us assume that the highest bid in the first month auction is Rs.100000. This is called the ‘discount’. The highest bidder now gets the amount equal to the chit value, less the discount, less 5% commission to the foreman, i.e. Rs.375000. The discount amount is then divided among the 50 members equally (the dividend for the 50 members work out to roughly Rs.2000 each). For the subsequent month, therefore, the contribution of these members reduces by the amount of dividend (i.e. the contribution in the second month for the members would be Rs.8000. This process gets repeated for all months till the end of the scheme. The contributions are the same for each member, but the total amount taken out or bid by each member varies.

In case of default or delayed payment, the Chit Fund organizer has to put up the liquidity on behalf of the defaulting and delaying members.

1.3 Why people use Chit Funds?

In many parts of India, Chit Funds address gaps left by the traditional banking sector. They mobilize huge amounts of small savings, and in return allow members to have access in the form of loans to lump sum amount of money that they would often not be able to get from traditional banks. Easy accessibility and flexibility are important aspects of this form of financing. Compared to banks, Chit Funds require less documentation, are more flexible about collateral, and allow to determine own interest rate (within the constraints of a given chit scheme). Furthermore, there is no need to determine upfront whether funds are used for saving or borrowing. This is a salient feature of chit funds as it not only puts in place a disciplined saving mechanism, but it also allows access to cash when needed. In addition, as Chit Funds use the funds of the participants, there is much less capital requirements for the institution (unlike banks).

The primary uses of Chit Funds include:-

    To address consumption needs, such as, marriage, education, property purchase and so on.
    To pay off costlier loans from outside sources like loan from money lenders.
    To address working capital, business expansion or start-up capital needs of small businesses, besides providing bridge loans.
    For an emergency or simply as savings for future needs.

1.4 Characteristic of the Chit Fund Participants

A survey by Institute of Financial Management and Research, Chennai, reveal that approximately 80 percent of the participants in the registered chit fund industry are male and the average age is 40 to 45 years. It is also important to mention that more than 80 percent of the chit fund participants have more than high school level of education. In terms of the occupational characteristics approximately 40 percent of the participants are self-employed, 23 percent of the participants are salaried class in the private sector, 13 percent salaried class in the government sector and 10 percent are housewives.

1.5 Volume of Chit Funds

Capitalizing on the social networking and community participation, this institution has survived over several years even after the influx of several other organized financial institutions and the increased complexity of financial markets. Under this model, money is circulated to the entire cross section of our society; be it housewives, salaried class businessmen, government servants, club members under different names namely: Kitties, Bisies, Kuries, Chit funds etc. It is estimated that the value of Chit turnover in States like Kerala, Tamil Nadu, and Andhra etc are almost 10,000/- crore each per annum. Though no authentic figures are available, the size of the unregistered chit fund industry as estimated by the Association of Chit Funds is almost 100 times that of the registered ones. As the growth of this unregistered sector is not in the national interest, there is an urgent need to ascertain the exact volume and take remedial measure to contain the same. Value of each Chit registered with the office of Registrar in rural areas   is around Rs.1 lakh where as in urban and metro cities the average value goes up to a maximum of Rs.10 lakhs and Rs.50 lakhs, respectively

The presence of more than 30,000 registered chit operators generating employment opportunities for several lakh people either directly or indirectly especially in rural areas, without taking any subsidy from the government, speaks volumes for its strength in our national economy.

1.6 Background for Regulation

While traditionally chit funds primarily serve as a saving mechanism, commercially they act more like a financial intermediary bringing together borrowers and savers, aiming to channelize the liquidity from agents with surplus towards deficit spenders. At the time when banks were getting nationalized and the entire financial system was being restructured as per new regulations, the Government being aware of the popularity of the chit funds primarily among the lower income households brought this alternative informal financial institution under the network of the formal credit market. Regulation in the Chit Fund industry was brought about by the Government of India to address mainly the problem of misuse of informal Chit Funds by unscrupulous promoters and to have a level playing field for the Industry throughout.

1.7 Introduction to Chit Fund Act

The first enactment on chit funds was by Government of Travancore (Kerala) in the year 1932, which was later followed by Madras Chit Fund Act 1961, Kerala Chitties Act 1975 etc.  The Banking Commission while examining in depth the activities of the non-banking financial intermediaries in early 1970s had, inter alia, recommended that it is essential to have uniform chit legislation applicable to the whole of the country. The Reserve Bank of India (RBI), at the instance of the Government, accordingly drafted a Model Bill for the Chit Fund. RBI also sent the draft bill to the study group under the Chairmanship of Shri James S. Raj. On the recommendation of this Committee, a special Act was formulated under the name of 'The Chit Funds Act 1982' by the Parliament which now provides for minimum capital requirement for companies for conducting chit business, a ceiling on the aggregate chit amount -which is 10 times of the net-owned funds, a self-contained machinery for settlement of disputes etc; and a number of penal provision for various defaults.

The Central Act has been notified in all the States like Tamil Nadu, Andhra Pradesh, Karnataka, Maharashtra, Rajasthan, Uttar Pradesh, West Bengal, Delhi, Kerala and Haryana etc.

1.8 Unregistered Chit Funds

With insufficient and/or volatile income streams, rural households heavily depend on various credit options from a basket of formal and informal financial sources.  Recent survey by Institute of Financial Management an Research, Chennai reveal that 71% of the households take loans mainly for health expenditures (28%), which highlight an urgent need for not only providing affordable subsidized health facilities but also financial services and schemes directed to health services. People clustered around the poverty line have different incentives and requirements when compared to the middle and high income groups. Essentially what we see is that poor and vulnerable segment is particularly at risk of being further squeezed as they are dependent on informal sources for credit like friends/family and money lenders and use credit to meet basic needs like household consumption requirements (21%), meeting expenditures during financial difficulties (17%) and also to repay loans (15%). While friends and families are a convenient and relatively benign form of finance, it is worthwhile to take cognizance of the fact that typically friends and families of people in this segment may not have sufficient money to spare since in all likelihood they also belong to this segment and are also hard pressed for their needs. Also in situations when the demand is inelastic, money lenders can take advantage of the urgency and charge exorbitant interest rates. Middle and High Income groups rely more on formal sources like banks and SHG’s to avail loans. General credit behavior predicts the chit usage between these two groups with the poor and vulnerable group focusing on immediate and basic needs like household consumption expenditure, emergency needs and repaying loans while the middle and high income groups have a more diversified usage.

The unregistered chits operate in different models. The profile of the participants of the Beesi model in Maharashtra is typically a married woman who is not the main bread winner of the house, frequent contributions in Beesi not only provides her a safe outlet for savings but also helps her to get a degree of control over her household resources which she can use to increase household assets and smoothen out consumption needs. It is a forced savings mechanism, sometimes even without the knowledge of the husband which increases the saving rates of the household, which may not be possible if the same amount was saved at home. In Karnataka, the pot money is mainly used to meet business expenses (25%) where as in Andhra Pradesh, the pot money is used more to meet basic needs of household expenses. Kitty parties among the urban house wives need no introduction.

Unregistered chits are popular because of various improvisations in the chit model at the informal and local level in the villages to overcome drawbacks like conducting multiple auctions to increase liquidity, availing loans from the wining chit scheme member and leeway in making late payments etc which is not possible in the case of registered chits. Philanthropic organizations like Bill and Melinda Gates Foundation find huge scope in streamlining this activity and enhancing its reach to the underprivileged, due to the inherent merits of the scheme when compared to Micro Finance Institutions and other financial institutions.

Extra effort on the part of the legislators and administers are needed all the more when the volume of such single pot is as high as Rs.1 core especially in wholesale markets in the metropolitan cities. Relaxing the rigors of the Chit Fund Act 1982 could be an effective remedy to eradicating this evil and curtailing the parallel economy

1.9 The tie –up with Bill and Melinda Gates Foundation

While the “Financial Inclusion Program” is of recent origin, whereas Chit Funds and other informal Financial Institutions, knowingly or unknowingly are already implementing this, for the last several decades, catering to those cross sections, which are beyond the reach of Banking and other Financial Intermediaries.  M/s Bill and Melinda Gates Foundation has come out to reach the economically weaker section of the society through Chit Fund companies; under their ‘Poverty Alleviation Program’. The maiden survey recently conducted on the working of chit Funds by M/s Institute of Financial Management and Research, Chennai under the Aegis of the Gates Foundation is an eye opener unraveling the inherent potential of this industry and suggesting ways and means to enhance its services to the deserving lot, in context of the current economic policies. The potential of this Industry to cater to the Lower and Middle Income Households is quite substantial, which is possible only with the legislative and Administrative support.

II Recommendation of the Core committee of the Key Advisory Group – Yet to be accepted by the Ministry

2. Chit Funds are an integral part of the financial networking in our society since time immemorial. As any suggestion / recommendation can be given effect only with Legislative and Administrative support, amendment of the Chit Fund Act 1982 will be the logical step in this direction.

The Act is a modified version of the Cochin Kuries Act 1932 and naturally not in tune with the liberalization policies and the Financial Sector Reforms, and thus has to be modernized. We are given to understand that even the Registrar of Chits are of the view that, once the prudential norms, capital adequacy norms, Investor protection measures etc are in place, provisions for day-to-day sanctions from the office of the Registrar should be done away with. It is not the mere formulation of an Act, but its effective implementation that matters.

2.1 Insurance coverage

The Act rightly provides Penal provisions for various defaults on the part of the foreman but the subscribers’ main concern is safety and security of their money in the hands of the foreman and not the punitive provisions of the Act as such. So, extending Insurance coverage to the subscribers money in the hands of the Forman may be a prudent initiative. Extending insurance coverage, apart from safe-guarding the hard earned money of the subscribing public, will make good business sense for the Insurance companies.

2.2 Securitization facility

RBI rightly has prohibited Chit companies from accepting any deposit from the public but at the same time there should be some options for arranging liquidity, in order to enable the foreman to honor their commitments to the chit subscribers. Securitization can be a right step in this direction. This may also be permitted to raise funds with in his frame work of his functioning. There is a need for a dialogue with Asset Reconstruction Companies by the Chit Fund Associations.

2.3 Value addition to the Chit Industry

The Chit Fund Association’s request to allow undertaking fee based activity like selling insurance policies and other financial products seems fair. The availability of Credit history is essential in the context of selling these products from the banks and other deposit taking institutions. The data bank that the chit fund companies have on this information qualifies them to undertake procurement, processing and disbursement of such products very effectively in view of their skill on intrinsic evaluation, cost effectiveness, market intelligence and quality of ownership. This will also benefit those cross sections that are beyond the reach of banking and other financial intermediaries.

2.4 Grievance redressal cell

We are of the opinion that the Chit Fund Association/Promoters should take the primary responsibility of addressing the subscribers’ grievances. A grievance redressal cell may be constituted which can consist of a representative of the Registrar of Chit Funds, a representative of the Chit Association and representative of the subscribing public/or anyone as decided by the advisory panel so that complaints, as and when occur, can be resolved in the elementary stages. Though the proposed cell may not have legal sanctity, we are given to understand that it has yielded result in States where it had been voluntarily set up.

2.5 Rating of chit fund companies

We find that chit funds traditionally operate on a small scale; foreman-participant as well as intra-participant relations is based upon mutual trust and personal information. The smaller Chit Funds have higher overheads and less capital cushioning but often provide more customized services and personalized attention to their clients. The larger Chit Funds are regarded as financially more reliable. To be successful and acceptable at an increased size and scale, chit funds need transparent processes, risk identification and management strategies, a pool of useful products, professional management, proper documentation, increased use of technology and financial strength to bear the risks.  Brand recognition comes with this type of professional management.  Though some process certifications, (such as ISO) exist, a holistic assessment of the quality of governance and strategies, strength of risk management and operating systems, legal compliance and financial performance can be delivered only by undergoing a detailed performance rating process. Hence it is recommended that ‘Ratings’ be given by agencies like M-CRIL / CRISIL which will be beneficial both to the subscribing public and also motivate the chit promoters to excel.

2.6 Formation of SRO

It’s high time that Chit Funds constitute an SRO, which we understand has also been suggested many times by RBI, as in the case of Bar Association of India, Institute of Chartered Accountants, and Medical Council for Doctors etc. The said SRO will further increase the transparency and ethical practices. This body can keep a tab on the chit promoters and can act as a deterrent for the erring companies thereby reducing the burden on the administrators.  This forum may further help in

    Advocacy of best practices
    Corporate Governance
    Best financial practices
    Ethical behavior
    Educational and awareness activities

2.7 Requirement of a common Registrar

One major drawback we find is that activities of any company in one State are not made known to the Registrar of another State. Creation of the post of a ‘Common Registrar’ for all the States will enable the working status of companies in different States and look into the complaints, if any, for the overall benefit of the subscribing public. The respective State Registrar can keep posting computerized financial and other relevant reports on a periodical basis.

Easy availability of the computerized information to the public from the office of the Common Registrar, based on a few points, and not the entire balance sheet, and some awareness program to the extent that they should deal only with companies who are in the approved list and not in the Black list etc will be enough to maintain effective control.  If any individual chooses to deal with a black listed company just for the sake of better returns, he will do so at his own risk.  Risk taking behavior is inherent in human nature and undue concern on the part of the Reserve Bank of India or other departments to protect the public who knowingly land themselves in the hands of unscrupulous elements in our opinion is unwarranted.  Over regulation can only result in increasing corruption and is against the ongoing liberalization program.

In fact the activities of all the non-banking financial institutions can be monitored by this common Registrar.

2.8 Formation of Advisory Committee for future control

One reason standing in the way of amendment could be the lack of coordination between RBI, Central and the State Governments which we have seen in other spheres as well. Formation of this Advisory Committee, which is informal and independent in nature is a simple and ideal solution in enabling the departments in maintaining transparency, take the affected parties into confidence and make things happen on a time bound manner. Making this committee permanent and strengthening it with more powers may be the next logical step. The tenure of this panel should be for a period of around three years or so and the members should be replaced on a partial rotation basis in order to maintain continuity.

2.9 Amendment of Chit Fund Act 1982

We had very detailed discussions with the Association members. We do agree that Amendment of Act is the first requirement if Chit Funds have to be encouraged to play a more effective role in the Financial Inclusion Programme.

A brief description of the above issues under consideration with the department for amendment and our recommendation is as follows.

Section 2(b) – There is no harm in considering the demand of the Chit Fund Association to change the word ‘Chit Fund’ to ‘Fraternity Fund’ in the definition. This may help distinguish its working from the ‘Prize Chits’ which is banned under a separate legislation.

Though the contents of Section 12 provide for transacting other business with the permission of the State Government, the word ‘Prohibition’ in the heading may be replaced with the word ‘Permission’ as it is misleading.

Section 16 of the Chit Fund Act provide for 2 subscribers presence for the auction meaning thereby a needy subscriber cannot get the chit confirmed unless there are two more subscribers physically present. As we see it, when chit fund companies are working towards e-auction, advent of the electronic revolution and availability of facilities like e-payment etc., such requirements are hindering. It is recommended to look into the possibility of doing away with the 'physical' presence and permitting 'virtual' presence or ‘Proxy’ with a view to avoid practical difficulty and at the same time maintaining transparency.

Section 20(1) provide for 100% of the chit value to be deposited in a separate account for the proper conduct of the chits.  Even Deposit taking companies, as illustrated in the chart below shared with us by the chit fund association, do not have such restrictions. If this holds well, this Section may to be diluted, as it causes undue hardship and heavy financial burden on the chit promoter as the RBI Act prohibits him to take any deposit from the company shareholder or the public even to honor his commitment to the chit holders.

 
Object of the RBI Act         Relevant Sections
                           RBI ACT     Chit Fund Act 1982

Registration                 45  1A      Sec. 4 and 14 etc.,

Minimum capital requirements 45  1A       Sec. 8(1)

Prudential norms             45  1B       Sec. 13

Reserve Fund                 45  1C       Sec. 8(3)

Security deposit              NIL         20(1)(a)
            

If at all some amount is to be deposited that can be at the time of the commencement of the chit not at the time of previous sanction.

As we understand, one major difficulty for the promoters is getting previous sanction for each chit and filing the minutes of the auction proceedings etc on a monthly basis. As the office of the Registrar Chit Funds do not have the time to monitor such procedures on a case to case basis, it may be advisable to issue previous sanction on an annual or half yearly basis. Deposit security if needed can be done at the time of the commencement of each chit. Penal clause for violations, if any, can of course be made stringent to act as a deterrent.

One lacuna, we notice from the point of view of the subscribers, in the Chit Fund Act is that the needy members cannot be sure of getting financial support at a given time. In view of the urgent financial requirements like medical exigencies, education etc., several members look forward to some support even to the extent of money paid by them in the chit. As there are restrictions provided in this regard in Section 21(1), Section 14 and Section 22, we have no objection is acceding to the chit fund association’s request to modify the relevant sections in such a way so as the foreman is allowed to borrow money from the prized subscribers to the extent of their future liability and lend it to the non-prized subscribers to cater to the subscribers’ urgent financial needs.

As Chit funds are supposed to cater to the Lower and Middle Income Households who are beyond the reach of the banks and other intermediaries, a fact that has also been substantiated by report of IFMR etc., we see merit in granting necessary concessions for chits at least up to Rs.1lakh or even a little more. Section 20 and Section 63 may be amended accordingly.

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