A standard explanation that seems to be emerging about why Ponzi schemes keep occurring in different parts of the country is that India does not have enough banks. And this lack of banks leads people to invest in fraudulent Ponzi schemes.
A Ponzi scheme is a fraudulent investment scheme in which the illusion of high returns is created by taking money being brought in by new investors and passing it on to old investors whose investments are falling due and need to be redeemed.
K C Chakrabarty, the deputy governor, is the latest individual who has jumped onto the more banks equals fewer Ponzi schemes, bandwagon. “The fact that people have to rely on such entities for their saving needs indicates a failure on the part of the formal financial system to reach out to such groups and earn their trust and confidence through a transparent and responsive customer service regime,” Chakrabarty said yesterday.
“The need of the hour is to ensure that our unbanked population gains access to formal sources of finance, their reliance on informal channels and on the shadow banking system subsides and, in the process, consumer exploitation is curbed,” he added.
So what Chakrabarty is effectively saying is that only if people had a bank in their neighbourhood they would have stayed away from a Ponzi scheme like Saradha. While it simple to come to this conclusion which sounds quite logical, the truth is not as simple as it is being made out to be.
Lets consider a few Ponzi schemes that have done the rounds lately. MMM India which promises to double the investment every month, needs prospective investors to have bank accounts. So here is a Ponzi scheme which is using what Chakrabarty calls the ‘formal financial system’ to flourish.
Before that there was the Speak Asia Ponzi scheme. In this scheme investors needed to fill online surveys. Anyone who has access to internet in India is most likely to have access to a bank account as well. So people who invested in Speak Asia, did so because they wanted to not because they had no banks in their locality.
Then there are Ponzi schemes which involve investments in gold coins. People who can buy gold coins won’t have access to a bank account?
Or lets take the case of Emu Ponzi schemes which had become fairly popular in parts of Tamil Nadu. The pioneer among these schemes was Susi Emu Farms. It promised a return of at least Rs 1.44 lakh within two years, after an initial investment of Rs 1.5 lakh had been made. This was the model followed by nearly 100 odd emu Ponzi schemes that popped up after the success of Susi.
Again anyone who has Rs 1.5 lakh to invest in a Ponzi scheme will not have access to a bank? That is rather difficult to believe. As Dhirendra Kumar of Value Research puts it in a recent column“Could it be that all those people who put money into Saradha wouldn’t have done so if they had a bank in their neighbourhood? Very unlikely. A lot of the deposits seem to have come from towns where there would have been banks. Moreover, almost every ponzi scheme that has come to light in the last few years has actually flourished in towns and cities. The investors who fell for StockGuru or the Emu farms or other schemes all had access to legitimate alternatives.”
So what is it that gets people to put their hard earned money into Ponzi schemes rather than deposit it into banks? The simple answer is ‘greed’. We all want high returns from the investments we make. And Ponzi schemes typically offer significantly higher rates of return than other investment options that are available at any point of time.
Having said that ‘higher returns’ are not the only reason that lures people into Ponzi schemes. There are other factors at work, which along with the lure of higher returns, ends up making a deadly cocktail.
Typically people do not like handing over money to someone they do not know. In small towns, people end up investing money into a Ponzi scheme through an agent they happen to know. So even though they have no clue about the company they are investing in, they feel they are doing the right thing because they know the agent.
In the case of Saradha, agents of Peerless General Finance and Investment were used to collect money. Peerless had a good reputation among the people of West Bengal, having been in the business of collecting small savings since 1932. This helped Saradha establish the trust that it needed to, during its initial days of operation.
As a report in The Indian Express points out “The selection of agents, a crucial link in the chain, was done very carefully by Saradha. Those picked were generally ones who wielded influence in their locality and in whom people had confidence.”
What also helps is the fact that agents are paid reasonably high commissions, leading to a higher level of motivation and thus better service. The agents typically come to homes of prospective investors to get them to invest money. So clearly there is better service on offer unlike a bank. There is very little need for documentation ( PAN No, Address proof etc not required) as well, unlike is the case with a bank.
Let us briefly go back to the more banks fewer Ponzi schemes argument. As the Indian Express report cited earlier states “One important reason for chit funds mushrooming(they are really not chit funds, but Ponzi schemes) in West Bengal is the absence of easy access to banks and other financial institutions. According to an estimate of the state Finance Department, of the 37,000 villages in the state, nearly 27,767 have no bank branch.”
While villages may not have access to a bank, they do have access to post offices. And India Post runs many small savings schemes, in which people can deposit money. But in West Bengal people seemed to have stayed away from these schemes. A report published in December 2012, in The Hindu Business Line quotes Gautam Deb, a former housing minister as saying “small savings and post office collections in West Bengal during the April-October 2012 period were merely Rs 194 crore, against the targeted amount of Rs 8,370 crore.”
So why did people stay away from the post office schemes and get into Ponzi schemes? For one the returns offered on Ponzi schemes were significantly higher. The second reason obviously is the significantly better level of service that Ponzi schemes offer with agents getting higher commissions.
In fact, there are no commissions on offer for selling post office savings schemes. As Kumar points out in his column “The post office offers excellent schemes with a huge reach in rural and semi-urban areas but can it compete on sales and marketing? In fact, when the government eliminated commissions on PPF and other deposits in post offices in 2011, it effectively eliminated whatever little sales muscle there was.”
The formal financial system thus finds it very difficult to compete with unscrupulous operators like Saradha. It is not easy for it to offer higher commissions as and when it wants to simply because it has got rules and regulations to follow. As Kumar puts it “They (i.e. the Ponzi schemes) spend much more on sales commissions, on offices, keeping politicians happy and getting media coverage because they can just dip into the deposited money for all these expenses. Therefore, even if legitimate financial services are available passively, they won’t be able to compete.”
Another reason why the people of West Bengal fell for Saradha was the fact that the Ponzi scheme came to be very closely associated with Trinamool Congress, the party that rules the state. The ‘formal financial system’ cannot afford to do anything like that.
When we take all these reasons into account it is safe to say that the more banks fewer Ponzi schemes argument doesn’t really work. Even if more banks are established, the banks will not be able to compete with the level of service and commissions that Ponzi schemes can offer. Hence, it is very important that unscrupulous operators who are caught running Ponzi schemes are punished and justice is delivered as soon as possible. This will ensure that anyone who wants to start a Ponzi scheme will think twice before he acts. And that is the best way to protect people from Ponzi schemes.
The article originally appeared on www.firstpost.com on May 3, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)
In Ek Thi Daiyan, the latest horror flick to come out of Bollywood, the dying daiyan (witch) says something to the effect of “main wapas aaongi (I’ll be back).” Ponzi schemes are a tad like that. They keep coming back one after the other.
Only sometime back we were talking about the Stockguru Ponzi scheme. Before that the emu ponzi scheme and Speak Asia had been in the news. More recently the MMM Ponzi scheme and Saradha chit fund have taken up a lot of news space.
MMM India recently put itself into what it calls a calm regime where operations like money transfer will remain suspended and hence those who have put money into the scheme won’t be able to withdraw it. The Saradha Chit fund has collapsed.
The question is why do Ponzi schemes keep occurring over and over again in India? A popular explanation is that India is an under-banked country and that gets people to invest in Ponzi schemes rather than deposit money in the bank.
As The Economic Times points out in an editorial “the repeated sprouting of dubious Ponzi schemes across the country points to a failure of the formal saving and banking system.” This maybe true to some extent but does not really explain why Ponzi schemes keep cropping up all the time and why people invest in them.
Take the case of MMM India Ponzi scheme. To participate in it, an individual needed to have a bank account. To be a part of Speak Asia an individual had to participate in two online surveys per week. An individual who has access to an online connection is more than likely to have a bank account as well.
So Ponzi schemes are not just about India having fewer banks. There is a clear mental dimension at play which makes individuals invest in Ponzi schemes over and over again. And this makes sure that there are always scamsters looking to cash in.
Robert Shiller, an economist, defines a Ponzi scheme in a research paper titled From Efficient Market Theory to Behavioural Finance as follows: A Ponzi Scheme involves a plausible but unverifiable story about how money is made for the investors. It creates a false perception of high returns for initial investors by distributing to them money brought in by subsequent investors. Initial investor response to the scheme tends to be weak, but as successive rounds of high returns generate excitement, the story becomes increasingly believable and exciting to investors. Finally, the scheme collapses when new investors are not prepared to enter the scheme.
The phrase to mark in this definition is “high returns generate excitement”. Very recently, MMM India promised returns of 100% per month to prospective investors. The prospect of high returns pushes individuals to take on the risky bet of investing in a Ponzi scheme.
As Robert Shiller writes in Finance and the Good Society“The mere presence of uncertainty in a positive direction creates a pleasurable sensation (in the brain), and so the reward system creates an incentive to take on risky positive bets…This human tendency also helps explain why people like to gamble, and why many people will return every day to bet a small sum in a lottery. It also helps explain why people are willing to speculate aggressively on investments.”
This gets individuals to invest in a Ponzi scheme. And after one lot of investors has invested in a Ponzi scheme it tends to take on a life of its own. The initial lot of investors then become the advertisers for the scheme. If a person wants to invest, the chances are he will look around to see what his acquaintances, neighbours or relatives are doing with their money. If the people around the potential investor invest in a certain way, there might be a tendency for him to follow them. Much like the ‘circular mills’ of ants. The mill is created when an army of ants find themselves separated from their colony. Once they are lost they obey a simple rule: Follow the ant in front of you.
Decisions of investors, much like the circular mills of the ants, are not made at the same time but in a sequence. People who invest in the Ponzi Scheme assume that the scheme is a good bet simply because some of the people they know have already invested in it. So everyone ends up making the wrong decision because the initial investors get into the scheme by chance.
This happens because the attraction of easy money is something that investors cannot resist. Ponzi Schemes offer the prospect of huge returns in a short period of time vis a vis other investments available in the market at that point of time. Greed also results when investors see people they know make money through the Ponzi Scheme. As Charles Kindleberger wrote in Manias, Panics and Crashes “There is nothing so disturbing to one’s well being and judgement as to see a friend get rich”.
Overconfidence also has a part to play. Most people are confident that they won’t become victims of financial frauds. This also leads them to invest in Ponzi schemes. Ove
rconfidence is also at play when investors understand that they are getting into a Ponzi scheme, but they are still willing to enter the scheme, because they feel that some greater fools could be depended on to enter the scheme after they have and this would give them handsome returns on their investments.
The contract effect is also at play. It becomes relevant in the context of a Ponzi Scheme when the prospective investor starts comparing the returns on the various other investment avenues available in the market for investment at that point of time. The high returns of offered by a Ponzi scheme stand out clearly and attracts investors.
So a Ponzi scheme just doesn’t spread only because of a weak banking structure though that might be true in case of Sahara or even Saradha chit fund. Also it is important to remember the first sentence in Shiller’s definition of a Ponzi scheme, which is: “A Ponzi Scheme involves a plausible but unverifiable story about how money is made for the investors.”
So people running Ponzi schemes spend a lot of time in building a ‘supposed’ business model and building a great brand. The Saradha chit fund had built a huge media empire in West Bengal. It had also purchased a motorcycle company, to give some semblance of a business model to its investors.
Sahara is similarly into a lot of businesses and even sponsors the Indian cricket team. Similarly, Speak Asia was in the magazine and survey business. It also advertised majorly in the publications of The Times Group, to build credibility. Emu Ponzi schemes were in the business of rearing and selling emus. And Stockguru helped investors make money by investing in stocks.
MMM, in its original Russian avatar, sponsored the Russian football team in the 1994 football worldcup. When questions were raised about the huge returns, it had promised, MMM stated that it had solid investments, but did not want to disclose them as its competitors might imitate its investment strategy.
Over the years, investors have been fooled into investing their money into Ponzi Schemes which keep appearing in various forms. They ignore the most fundamental principle of investment theory: You cannot expect to make large profits without taking risk. Whenever a large amount of money is at stake, individuals should logically seek large amounts of information on where they should invest. But most investors do not do so. Few ask the right questions at the right time and are naïve enough to believe in what is communicated to them by the people carrying out the fraud.
Indeed, many Ponzi Schemes do not get reported as people do not like to admit that they have been fleeced because of their greed. The ones, which are reported and investigated, get stuck in the quagmire of our legal system. This encourages more people to run Ponzi Schemes. And every time a Ponzi scheme is exposed, the confidence of the investor in the financial system goes down.
The most commonly suggested solution for prevention of Ponzi Schemes is sharing more and more information with the investing public. But research in psychology shows that more information does not necessarily improve judgement. Any extra information is helpful only if it comes without any bias. But that is rarely the case. Moreover, the ability of the common man to assimilate information is limited.
Rather than assuming investors are knowledgeable about investment opportunities, the best solution to the problem of Ponzi schemes might be ensuring swift legal mechanisms to punish the unscrupulous masterminds behind the Ponzi Schemes. This will ensure that every prospective fraudster will think twice before launching another Ponzi scheme.
The article originally appeared on www.firstpost.com on April 23, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)