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A chit fund is a type of rotating savings and credit association system practiced in India. Chit fund schemes may be organized by financial institutions, or informally among friends, relatives, or neighbors. In some variations of chit funds, the savings are for a specific purpose. Chit funds are often microfinance organizations.
Chit funds also played an important role in the financial development of people of South Indian state of Kerala, by providing easier access to credit. In Kerala, chitty (chit fund) is a common phenomenon practiced by all sections of the society. A company named Kerala State Financial Enterprise exists under the Kerala State Government, whose main business activity is the chitty. The concept of chit funds entered public consciousness in the 19th century when Raja Rama Varma, ruler of erstwhile Cochin state gave a loan to a Syrian Christian trader, by keeping a certain portion of it to himself for other expenses and later he drew that money for the principle of equity.
According to All Kerala Kuri Foremen's Association, Kerala has around 5,000 chit companies, with Thrissur district accounting for the maximum of 3,000. These chit companies provide employment to about 35,000 persons directly and an equal number indirectly.
A chit fund comprises a group of members, called subscribers. An organizer, a company or a trusted relative or neighbor, brings the group together and administers the activities of the group. The organizer is compensated each month for their efforts. (The fee may be omitted in informal situations.)
The fund starts at an announced date and continues for the number of months equal to the number of subscribers. Each month, the subscribers put in their monthly installments into the pot. Then, an open auction is conducted to determine the lowest sum a subscriber is willing to take that month. For example, if the monthly installment is $1000 and there are 50 members, the pot in the first month will contain $50,000. If the auction determines a winner who is willing to accept $45,000 for that month, the surplus $5,000 is distributed to the other 49 members, after subtracting fees paid to the organizer. The subscriber who won the auction was able to access $45,000 in the first month and the others benefited in their share of the $5,000 surplus. The process repeats, distributing the auction amount to one member each month. All of the other subscribers, including the ones who took their share in a previous month, continue paying the monthly installments.
The system acts as a both a borrowing scheme, because subscribers are able to access large sums of money before they've paid the full amount. It also acts as a savings system, because each subscriber contributes every month and may retrieve a large sum in the future while receiving their share of the surpluses.
Variations of the system omit the auction part, instead drawing a winner by picking a chit out of a box. (The term chit fund comes from such an arrangement.)
Both organizers and subscribers in chit funds are exposed to credit risk because subscribers might default on their periodic payments. One analysis of data from two chit fund companies found that 35% of subscribers have defaulted at least once in their tenure at one of the companies and 24% of them have defaulted after taking winning an auction for the pot. Chit fund companies can sue defaulters in court but the procedure is time-consuming and is unlikely to produce a timely settlement. It's up to the chit fund organizers to vet the credit-worthiness of subscribers. To reduce the risk of default, some organizers also require subscribers who win auctions to submit sureties for their future liabilities.
Since chit fund payments aren't insured by the government, the system is a riskier method of saving than using a bank savings account.
Organised chit fund schemes are required to register with the Registrar of Firms, Societies and Chits. A chit fund company is a company that manages, conducts, or supervises such a chit fund, as defined in Section of the Chit Funds Act, 1982. According to Section 2(b) of the Chit Funds Act, 1982:
The following laws govern chit funds:
Some chit funds are conducted as a savings scheme for a specific purpose. An example is the Deepavali sweets fund, which has a specific end date about a week before Deepavali. Neighbourhood ladies pool their savings each week. They use this fund to buy and prepare sweets in bulk just before the Deepavali festival, and they distribute sweets to all members. Preparation of Deepavali sweets may be a time consuming and costly activity for individuals. Such a chit reduces costs, and relieves members from extra work in a busy festival season. Nowadays, such special purpose chits are conducted by jewellery shops, kitchenware shops, etc. to promote their products.
With the advent of ecommerce in India, chit funds have also started going online. Online chit funds conduct auctions, and subscribers can pay their monthly dues and receive the prize amounts online through online transactions, including electronic fund transfers.