Understanding Chit Fund Model
Chit fund model is prevalent even before the evolution of banking in India providing access to finance for the low income households. It caters to the needs of different sections of the society, mainly in the income-generating households. Chit schemes have traditionally been generic, differentiating only in value and duration. There are more than 30,000 registered chit operators having an annual turnover exceeding Rs.40000 Crores.
Chit funds are the Indian equivalent of the Rotating Savings and Credit Associations (ROSCA) that are famous throughout the world. ROSCAs are a means to “save and borrow‟ simultaneously. It is considered one of the best instruments to cater to the needs of the poor. It enables poor people to convert their small savings into lump sums. The concept of chit funds originated more than 1000 years ago. Initially it was in the form of an informal association of traders and households within communities, wherein the members contributed some money in return for an accumulated sum at the end of the tenure. Participation in Chit funds was mainly for the purpose of purchasing some property or, in other words, for “consumption‟ purposes. However, in recent times, there have been tremendous alterations in the constitution and functioning of Chit funds.
While in most places ROSCAs are user-owned and organized informally, in India, chit funds have been formally institutionalized as well. Legally recognized firms provide a variety of chit schemes. Under the Chit Fund Act, this industry is overregulated but under-governed. This institutionalization of the chit funds (a) makes it easier for poor or illiterate people to know exactly what different chit schemes the chit companies offer, (b) provides an option to people to participate in schemes where members need not know each other; hence there is a larger diversification of the idiosyncratic risks. This makes it easier to provide chit schemes in urban settings where social linkage among members might be weak, (c) ensures transparency in the operations, (d) given that the law determines the size of the bidding and the commission the company can charge, it encourages competition among chit fund firms to improve services to clients, and (e) legal recognition also helps the chit fund operators to scale their operations. It allows the chit fund operator to use the legal means to handle defaults and more importantly it infuses faith in the clients that there are sufficient checks and balances which will prevent opportunistic behavior. In return the chit fund companies take a fee from the clients to cover their expenses, in the form of a commission. The chit fund company provides a variety of mechanisms by which the savings of the members can be transformed into lump sums. The main mechanisms are; savings deposit which allow a lump sum to be enjoyed in future in exchange for a series of savings made at present, loans which allow a lump sum to be enjoyed at present in exchange for a series of savings to be made in the future and, insurance which allows a lump sum to be enjoyed at some unspecified future time (for example, daughter’s marriage) in exchange for a series of savings made both at present and in the future.
The maiden survey conducted on the working of chit funds by Small Enterprise Finance Centre of Institute of Financial Management and Research, Chennai and the report prepared by the Research Associates of IFMR under the guidance of a Professor of ISB, Hyderabad and a Professor of MIT Sloan School of Management, USA 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 the context of the current economic goals of the Government of India. The potential of this Industry to cater to the lower and middle income households is unlimited.
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. The discount money less fixed commission to foreman is then distributed among the members as “dividend‟ and in the subsequent month, the required contribution is brought down by the amount of dividend.
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 the formal banking. 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 allows 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 to access 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).
But therecent trends in the industry have led to a concerning evolution which haslimited the reach of the Chit Funds to poorer households.
·Chit Fundregulation have significantly increased the transaction costs for chits, andsince most of the costs have to be incurred for each additional member, theregulations could push funds away from serving the poor. As funds can onlyjustify the transaction costs per capita if the individual ticket size isrelatively large, this possibility cannot be ruled out.
· Shiftof Chit Funds from registered to unregistered or maturation of industry: Thefinancial exclusion of low-income households from the registered industry willpush them into the unregistered chit industry where their investments are lesssecure.
·Also, TheChit Fund Act, 1982 is obsolete and needs amendment to several provisions thatare inconsistent to the present times and practically not possible to adhereto.
All theabove stated explanations point to a disturbing trend within the Chit Fundindustry, as it is being compelled to exclude the poor from their target groupmainly because they are perceived to be unprofitable to serve. The followinghave also added to the woe of this industry.
ServiceTax / GST
Theimposition of Service Tax (Now GST), on this unique saving instrument,crushed the remaining life out of this traditional financial intermediary.
aHasrendered the chit model cost inefficient as neither the subscribers nor thechit promoters can afford to burden
b.Depictsthe step-motherly treatment meted out to the chit fund industry that has beensingled out for taxing while other NBFCs enjoy 90 to 100% abatement
c.Evenglobally financial services have been exempt from the Service Tax/GST net forobvious reasons that got exemption/abatement for other NBFCs in India as well.
While theChit industry had been pleading to increase the abatement from 30 to 90 or100%, to make it at par with other NBFCs, the implementation of GST has furtherdented our prospects as we have now ended up paying more than the Service Taxlevy. To explain, we were being charged at an effective rate of 10.5% (15% less abatementof 30%) in the service tax regime but in the GST it has been increased to 12%.The functionality of the chit funds is akin to banks and NBFCs who mobilizesavings from account holders and lend them to borrowers. The spread between theinterest rate on the deposits and lending is the earning of banks/NBFCs whichis used for administration of the activities. The foreman commission, capped at5%, is similar to the above referred spread.
Sec 269STof the Income Tax Act
A newSection 269ST was introduced in the Income Tax Act, 1961 (‘IT Act’) with acorresponding penal provision introduced in Section 271DA. With theintroduction of Section 269ST, cash receipts exceeding Rs.2 lacs are notpermitted and non-compliance of the same would trigger penal provisions andpenalty equivalent to the amount of cash receipt can be levied.
Government,Banking Companies, post office savings bank and cooperative banks have beenexempted from the provisions of Section 269ST with power accorded to theCentral Government to exempt further persons or class of persons or receipts.This exemptions has now been rightly extended toNBFCs & HFCs as well as it would have adversely affected theircollections thus increasing their NPA
While wewelcome this amendment which would discourage transactions in black money as itseeks to penalize the receiver, such a penal provision would be harsh on anindustry such as ours which in fact has been playing a greater role inmobilizing small cash pockets into the larger financial system by bringing theminto the banking channels which is exactly what is sought to be achieved bySection 269 ST.
Rationalefor granting relief to Chit Funds:
· ChitFund industry; predominantly channelize the savings of lower and middle incomegroups. A sizeable proportion of this income group receives theirincomes in cash and is still new to the Banking system.
· ChitFunds play the role of financial intermediary in bringing the cash availablewith the low and medium income households into umbrella of the banking systemand thus are akin to banking companies and post offices who have been conferredrelief from complying with Section 269 ST.
· Themain reason for introducing Section 269 ST is that the unaccounted wealthis stored and used in cash. The organized chit fund industry,catering to the needs of the lower income groups in providing attractive meansof investment and hassle free availability of finance for personal andentrepreneurial needs are in fact doing the role of ensuring that wealth doesnot remain stored and used in cash and are ploughed to the mainstream economy.To reiterate, proceeds to prized subscribers are always paid through accountpayee cheques and never in cash
· Allvital information including name, address, proof of identity etc. are collectedand maintained in the database of all registered chit fund entities. Thisinformation is also submitted to the Registrar of Chits in respective States.
Though wehave submitted several representations to the concerned departments, this PressMeet is another attempt to highlight our plight and seek redress.
1 Bring in Amendment tothe Chit Fund Act, 1982
The processof amendment started about five years ago with the setting up of a Key AdvisoryGroup (KAG) on Chit Funds by the Department of Financial Services (DFS),Government of India with participation from all stakeholders, RBI, StateGovernments, Industry Confederations, relevant departments and reputedconsultancy firms. The report of the KAG with recommendation of sweepingreforms and amendment to several provisions of the outdated Act was submittedmore than 4 years back. The Parliamentary Standing Committee on Finance, inagreement with the recommendations of the KAG had pulled up the DFS for notimplementing the report. However, till date, the process of amendment has notbeen initiated!
2 Grantexemption/Lower slab in GST
Representations,on merit, have been made to the concerned departments. This levy is just notfeasible on the chit model and if for any reason exemption is not possible, weshould at least be taxed in a manner so to make the effective rate of levysimilar to other NBFCs.
3 Grant exemption fromthe harsh implications of Section 269ST, on an equal footing with that ofbanking companies, NBFCs, HFCs, as it would adversely affect our collectionsand thus increase the NPA
4.Toolfor Financial Inclusion
Chit Funds, unlike other formal sources of finance,are “bottom-up” institutions – schemes typically begin only when a group isready to participate and scheme values reflect the needs of the members in thescheme. Given the importance and magnitude of the efforts needed to achieve theobjectives of financial inclusion, there is an urgent need to recognise andsupport the role of this uniquely democratic and potentially seriouscontributor.As the gapbetween the banking and the informal Banking sector is quite huge and as thefinancial inclusion are mostly on papers and seminars, with the grass rootconnection the chit promoters maintain it will be a win-win situation for oureconomic agenda.