In the past few weeks, the local government of West Bengal has been embroiled in a financial and political crisis that has potentially large impacts on the state’s poor and its MFIs. After discovering that the commercial entity the Saradha Group had duped thousands of investors through a real estate Ponzi scheme, the state minister launched a full investigation of over 70 other deposit-taking entities which are grouped under the category of “chit funds.”
A chit fund is a ROSCA-meets-the-auction block style of Indian savings scheme in which subscribers pool money every month and then try to outbid each other to get the entire pot. The difference between the lowest bid and what is left in the pool is distributed among members. In West Bengal, chit funds are particularly important due to the high demand for products that accommodate small savings. According to Abhijit Banerjee and Maitreesh Ghatak, West Bengal’s share of population was approximately 7.5% in 2011, its state domestic product was 6.7% of India’s GDP, but its share of bank deposits was 22%. Many of the state’s poor cannot afford to open a bank account and those who can face plummeting interest rates. Chit funds can offer an alternative to traditional savings and credit lines for the unbanked.
The combination of low returns on traditional savings accounts and the unmet savings needs of the poor creates a perfect storm for unscrupulous investments and Ponzi schemes like those initiated by Saradha. The government’s response to the recent crisis was a quick bailout to recoup the losses for Saradha investors but this action has sparked a larger debate on the need for more stringent financial regulation for any entity that manages savings, including MFIs. Currently India does have an official registry of chit funds and legislation that places limits on fund administrators such as caps on commissions. However, Saradha Group and the other 70-plus companies being investigated were not registered chit funds. In fact, in Kerala chit fund operators were registering outside of the state to avoid regulations until the Supreme Court banned this practice in 2012.
In addition to the lack of a strong regulatory environment, the Saradha crisis was enabled by the use of technology. Many fund managers exploited faulty software to register deposits and print phony receipts, creating very believable ledgers that helped them hide what was actually going on. The Saradha incident is a prime example that technology is a tool that can be used for both increasing transparency and obscurity.
Advocates for electronic payments and other financial innovations often blame overly complex regulations for delaying the roll out of useful services for unbanked households. The crisis in West Bengal should offer a reminder that those regulations exist for a reason; they’re not just red-tape and bureaucratic rent-seeking. Protecting the assets of the poor is a good and necessary policy goal. How to provide protection without driving providers out of the market entirely and allowing space for innovation is a difficult balancing act.