Central bank governors rarely indulge in any plain speak. You have to always read between the lines to understand what they are really saying. They never say what they mean. And they never mean what they say.
But D Subbrarao, the governor of the Reserve Bank of India, indulged in some plain speaking on Wednesday and questioned the logic of the Mamata Banerjee government in West Bengal setting up a Rs 500 crore relief fund to compensate the losses of those people who had invested in deposits raised by the Saradha Group in West Bengal.
A part of this relief fund will be funded by a 10% tax on cigarettes and the rest of the money will be raised through other sources. “If you go back to the West Bengal Saradha scheme, the Chief Minister said ‘I will levy additional taxes on cigarettes and some other things to compensate the people who have lost money’ … Is it fair?” Subbarao asked.
Why should people who smoke fund those whose money has gone up in smoke, is a reasonable question to ask. It is like robbing Peter to pay Paul.
Subbarao also dwelled into why Ponzi schemes like Saradha have become fairly popular. “The reason it (the Ponzi schemes) is happening because ordinary people… the low income people are not sufficiently aware of where they can put their money. They don’t have enough avenues to put their money. They can’t get into the banks like we all do. They face both formal and informal barriers…So they fall prey to these fraudulent schemes,” Subbarao explained.
This is an explanation similar to the one his deputy K C Chakrabarty had come up with a few days back when he said: “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.”
This is a very one-dimensional explanation of why Ponzi schemes have become so popular in India in the last few years. Ponzi scheme is a fraudulent investment scheme where the money being brought in by newer investors is used to pay off older investors. The scheme offers high returns and it keeps running till the money being brought in by the newer investors is greater than the money needed to pay off the older investors whose investment is up for redemption. The moment this breaks, the scheme collapses.
This writer has explained in the past that lack of a bank in their neighbourhood is not a reason good enough to explain why people invest money in Ponzi schemes. Many of the Ponzi schemes over the last few years have been very popular in urban as well as semi-urban areas, where there are enough number of banks going around. At the same time some of the Ponzi schemes have even needed bank accounts to ensure participate. So saying that people invest in Ponzi schemes because there are not enough banks going around, is not good enough. There are other bigger factors at work.
Ponzi schemes have become a big menace in India over the last few years. There numbers have gone up many times over. While there is no hard data to support the claim, but there is enough anecdotal evidence going around. Be it Speak Asia or Stock Guru or MMM India or Emu Ponzi schemes etc, there has been endless list of Ponzi schemes hitting the market.
This has also been a period of high inflation where interest offered on fixed deposits and postal savings deposits, has been very low or even negative once it is adjusted for inflation. There are other reasons as well why people find fixed deposits and postal savings deposits unattractive.
As Ila Patnaik wrote in a recent column in The Indian Express “Even those who have access often find it unattractive. Interest rates paid to depositors have been pushed down through years of policies of administered interest rates and lack of competition in banking. Regulatory requirements for priority sector lending and holding of government bonds have further resulted in lower returns. The result is low or negative real interest rates for depositors.”
It has been an era where bank fixed deposits have offered around 9% interest before tax when the inflation has been at 10% or more. The returns from post office savings deposits have been even lower than bank fixed deposits. Hence, in the strictest sense of the term, money deposited in banks or post office, has essentially been a losing proposition, given the high inflationary scenario that has prevailed.
And not surprisingly in this situation people have been looking at other investment avenues where there is a prospect of making higher returns. Gold has been one such investment avenue. As the Economic Survey released by the government in late February this year pointed out “Gold imports are positively correlated with inflation. High inflation reduces the return on other financial instruments… This observation, in line with global trends, is easily explained by the declining real returns on the gamut of financial instruments available to the investor and soaring ones on gold (23.7 per cent annual average return between April 2007 – March 2012 versus 7.3 per cent return on Nifty and 8.2 per cent on savings deposits).”
So money came into gold because there was a prospect of earning a high real return instead of bank and post office deposits where the individual would have actually lost money after adjusting for high inflation.
A similar explanation can be offered for people investing their hard earned money in Ponzi schemes like Saradha. They were looking for a higher return which helped them at least beat the rate of inflation. And this is where Ponzi schemes like Saradha came in. These schemes offered deposits which promised higher returns than bank or post office deposits.
As an article in the Business Standard pointed out “Sen(in reference to Sudipta Sen who ran Saradha) offered fixed deposits, recurring deposits and monthly income schemes. The returns promised were handsome. In fixed deposits, for instance, Sen promised to multiply the principal 1.5 times in two-and-a-half years, 2.5 times in 5 years and 4 times in 7 years. High-value depositors were told they would get a free trip to “Singapur”.”
In case of Saradha, the credibility it had built through its media empire as well as being seen closely aligned to the ruling Trinamool Congress, also helped. The deposits being raised may have even been seen as very safe, by those investing.
The other thing that has happened over the last few years is that household savings have come down. In 2009-2010 (i.e. the period between April 1, 2009 and March 31, 2010), savings stood at 25.2% of the gross domestic product (GDP). In 2011-2012 (i.e. the period between April 1, 2011 and March 31, 2012) the savings had fallen by nearly three percentage points to 22.3% of the GDP.
This has primarily happened because of high inflation which has pushed up expenditure as a proportion of total income. But incomes haven’t gone up at the same pace. And this has led to a fall in savings.
Given that savings of people have come down, there might be a temptation to invest them in avenues where they thought a higher return could be earned so as to ensure that investment goals continue to be on track, even with a lesser amount of savings being invested. This might have increased people’s appetite for taking on investment risk.
Hence, high inflation may have had a big role to play in people investing their money in Ponzi schemes. And we all know who is to be blamed for that.
Inflation has had Subbarao worried for a while now. “There is an important constituency in the country that is hurt by inflation. Their voice also needs to be heard. It is the responsibility of public policy institutions like the Reserve Bank to go out of our way and listen to silent voices,” the RBI governor said on Wednesday.
To conclude, it is very easy to argue that more Ponzi schemes spread because people people lack access to basic banking. But the reality is a little more complicated than that. As they say, truth is often stranger than fiction.
The article originally appeared on www.firstpost.com on May 9,2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)
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)
Over the last few days, chit funds have been renamed. They are now called “cheat funds”. This has happened in the aftermath of the Saradha Chit Fund going bust in West Bengal. But as this writer explained yesterday, Saradha was not a chit fund at all.
Estimates suggest that chit funds have been around for more than 1000 years. World over they are typically referred to as Rotating Savings and Credit Associations. While the details might vary from one chit fund to another, there is a basic structure to a chit fund. And that is what makes it enduring.
Lets try and understand this in some detail. A chit fund admits a certain number of members, who contribute a fixed sum of money every month. The total amount that is accumulated from the contributions made by the members of the chit fund is referred to as the ‘pot’.
Lets consider a chit fund which admits 25 members. Each of these members contribute Rs 2,000 per month. The value of the pot every month is thus Rs 50,000 (25 x Rs 2,000). Members of the chit fund bid for the pot. The amounts the members bid for the pot is referred to as the ‘discount’. The member bidding the highest discount gets the pot minus the discount and an organiser fees that needs to be paid to the individual or the company running the chit fund.
So lets say that the highest discount for the first month in the example being considered is Rs 12,500. Other than this there is an organiser fees of 5% of the value of the pot. This amounts to Rs 2,500 (5% of Rs 50,000). Hence, the member who has bid the highest discount will get Rs 35,000 (Rs 50,000 – Rs 2,500 – Rs 12,500).
The highest discount bid becomes a profit for the chit fund. While it raises Rs 50,000, it needs to distribute only Rs 35,000. Of this the discount is Rs 12,500 and Rs 2,500 goes to the organiser of the chit fund.
The discount is distributed equally among the members of the chit fund and is referred to as dividend. In this case every member will get a dividend of Rs 500 (Rs 12,500/ 25). This amount need not be paid out and can be adjusted against the contribution of Rs 2,000 to be paid by members, in the next month. This means members will have to contribute Rs 1,500 each, in the next month. This is the basic structure of a chit fund.
Are chit funds modes of saving or modes of borrowing?
The answer is they are both. Typically those who enter a chit fund to borrow make high discount bids during the first few months. They are desperate for the money and want to ensure that they land up with the ‘pot’ sooner rather than later.
Mudit Kapor and Antoinette Schoar explore this phenomenon in a research paper titled Chit Funds as an Innovative Access to Finance for Low-income Households. They consider a chit fund with 25 members where each member contributes Rs 2,000 per month. This the is most common scheme, Kapoor and Schoar point out. As they write “The most common scheme is the chit value of Rs. 50,000 ($1000) for the duration of 25 months…In the first five months, bidding amount is usually high with members most urgently in need of funds…bidding. Afterwards, bid amount tends to decrease overtime. Inversely, members’ contribution will increase overtime as the dividend amount decreases.”
So a member who bids a discount of Rs 12,500 for a pot amounting to Rs 50,000 is very desperate for money. In a way the discount is an interest that the member of the chit fund is ready to pay to have access to a bulk amount. He does recover some of this discount in the dividends that he gets in the months to come.
As Kapoor and Schoar write“Our analysis of the bidding data shows that the average loan interest rate ranges between none (when the member is a saver in the scheme and does not bid) up to 3.5% per month for a 25 month scheme. Usually the interest rate peaks when approximately 1/3rd to 1/4th of the tenure is over.”
Typically during the last few months of a chit fund the highest discount comes close to zero. By then, the members who are still to get the pot, are those who are in the chit fund to save money and thus they are in no hurry to get hold of the ‘pot’. Given this the highest discount bids starts to fall in value over the tenure of the chit fund.
What kind of returns do chit funds give?
People who enter a chit fund to borrow money, end up bidding for the pot with very high discounts. This ensures that they end up paying an ‘effective’ interest. These individuals do not make any return from the chit fund.
Those who enter a chit fund to save money end up making money. But their returns depend on the level of desperation of other members who have entered the chit fund to borrow money. The higher the discount that other members who need to borrow money, bid, the greater is the return that people who are in the chit fund to save money, make. This is because higher discounts mean higher dividends.
So the greater the number of borrowers in a chit fund, the higher is the return that savers usually tend to make. Having said that, it is difficult to predict the kind of returns to expect given that there are too many variables at play.
Chit funds tend to claim that an individual “who is a saving member up to the last installments gets dividend which is comparatively higher than the interest that are accrued by way of Recurring Deposit Schemes.” This can’t be said for sure. If a chit fund is skewed and has significantly higher saving members than borrowers this might not turn out to be true given that members will not be in a hurry to get hold of the pot and thus will not bid high discounts for it. This will limit overall returns. Hence, members entering a chit fund to save money and earn returns cannot know for sure what kind of returns they will end up with unlike a recurring deposit.
What are the other risks of investing in a chit fund?
Chit funds need to be registered under the Chit Funds Act 1982 or under any of the acts promulgated by the various state governments. Any chit fund which has a pot greater than Rs 100, needs to be registered. The trouble is that a lot of chit funds are not registered. Kapoor and Schoar estimate that “on average the size of unregistered Chit Funds is about 67 times of the registered industry in Delhi and 3.1 times in Chennai. In the rural areas, the proportion of unregistered to registered Chit Funds might be much higher.”
Another estimate made by Preethi Rao in a research paper titled Chit Funds – A Boon to the Small Enterprises suggests that there are around 6000 unregistered chit funds in Hyderabad. A lot of these chit funds are run by fly by night kind of operators.
A registered chit fund needs to deposit 100% of the value of the ‘pot’ with the Registrar of Chits in the state, prior to the commencement of the chit scheme. Due to this, in the first month of operation of a chit fund there is no auction. The pot is handed over to the organiser of the chit fund to compensate him for the money that he has to deposit with the Registrar of Chits.
Trouble erupts when this tradition spills over even into the domain of unregistered chit funds. The organiser of the scheme is allowed first access to the pot. In many cases, the organiser can just scoot after he has been handed over the money. People have been known to lose a lot of money in such cases. This is a big risk when it comes to putting money into a chit fund.
What if a member defaults?
Also there is the risk of members stopping their contributions once they have won the pot. The chances of this happening are higher in an unregistered chit fund. In a registered fund there are legal ways to address this option. “When members fail to make their contribution for any particular month, they are initially requested by oral correspondence to pay the dues. If this fails, a reminder is sent by mail and finally a legal notice is issued and the person is taken to,” writes Rao. But as we all know legal options take time in India.
The other risk is that a chit fund gives out the pot only to one person at a time. A person who needs the money immediately may not get it because another person has outbid him by offering a higher discount for access to the pot. As Rao writes “Where two members are equally in urgent need of the loan in any particular month, the chit manager may allow them to make compromises among themselves wherein they may divide the ’pot’ equally between them. However, in such cases, one of them will be held liable directly to the group for the entire amount and the other would be liable to the former for his/her share of the loan.”
Rig up the discount
It is also possible for the organiser of the chit fund to rig up the discount bid. This involves those close to the organiser of the chit fund bidding high discounts for access to the pot. This sets the bar high and leads to a member who is desperate to access the pot offering an even higher discount. This practise was rampant during the early years of India’s independence. As The Economic Weekly pointed out in an article titled Legislation for Chit Funds published in its edition dated May 5,1962 “A common modus operandi is for a number of representatives of the company to subscribe to a chit scries. At the auction, they bid high to raise the rate of discount. In one case, for instance, it was found that a chit valuing Rs 2,500 (i.e. the pot) was auctioned for as low as Rs 1,675. This way the promoters swell their commission which is a fixed percentage of dividends.”
What this meant was that for a pot of Rs 2,500 a discount of Rs 1,675 was offered. To limit these kind of practises, the government has since introduced legislation which limits discount to 40% of the total value of the pot. “This bid-cap is administered to ensure that the bid does not rise uncontrollably leading to subsequent default by the bidder,” write Kapoor and Schoar. While registered chit funds have to follow this regulation, there is no way of knowing what unregistered chit funds do about this.
How does the organiser of the chit fund make money?
An organiser of a chit fund makes money by charging a fees of 5% of the total amount of the pot. That we have already seen. There is another less evident way in which he makes money. The highest bidder for the pot is not given the money immediately. “For instance, it is a common phenomenon for the loan to be disbursed a month after the auction date. This means that the chit manager will earn interest on the loan amount for a whole month. When this repeats for every scheme in force, a large quantity of money accumulates,” writes Rao. “To illustrate this, let us consider a chit scheme that has an auction on the 7th of January. The contributions will be collected on the 1st of January. Now, the prized subscriber at the auction will be provided with the loan amount or the ’pot’ only after a month, i.e. on the 7th of February. The chit manager will earn the interest on the collected amount essentially from the 1st of January to the 7th of February,” she adds.
Given this it is not surprising that some organisers of chit funds have become extremely rich.
To conclude, the points discussed above seem to suggest that those who have access to a bank account, should stick to dealing with banks, rather than run after chit funds. The returns are fairly unpredictable for savers, the interest paid by borrowers is very high and there are too many things that can go wrong.
The article originally appeared on www.firstpost.com on May 1, 2013
Vivek Kaul is a writer. He tweets @kaul_vivek
Saradha chit fund has been in the news lately for all the wrong reasons. But the question that no one seems to be answering is whether Saradha chit fund was really a chit fund? A little bit of digging tells us that Saradha was nowhere near a chit fund. It was nothing but a Ponzi scheme, where money brought in by new investors was used to pay off the old investors. Before we get into the details, lets first try and understand what exactly is a chit fund.
A chit fund is basically a kitty party with a twist.
Yes, you read it right.
The essential part of any kitty party organised by ‘bored’ housewives across India, other than the eating, drinking and gossiping, is the money that is pooled together. So lets say a kitty has twelve women participating in it, with each one of them putting Rs 5,000 per month. The women meet once a month.
When they pool their money together it works out to a total of Rs 60,000 every month. Twelve names are written on chits of paper. From these twelve chits, one chit is drawn. And the woman whose name is on the chit gets the Rs 60,000 that has been pooled together.
When they meet next month eleven names are written on chits of paper and one chit is drawn. The woman who got the money the first time around is left out because she has already got the money once. The woman whose name is on the chit gets the Rs 60,000 that has been pooled together this time around. And so the system works. Every month a chit is drawn and the pooled money is handed over to the woman whose name is on the chit that has been picked.
Of course, the women need to keep paying Rs 5,000 per month, even after they have got Rs 60,000 once. By the time the women meet for the twelfth time everyone who is in on the kitty gets Rs 60,000 once. And that is how a kitty more or less works.
So what is a chit fund?
A chit fund works more or less along similar lines but with a slight twist. Lets assume that the 12 women that we considered earlier come together and decide to contribute Rs 5,000 every month, as they had in the previous case. This means a total of Rs 60,000 will be collected every month. This amount is then auctioned among the 12 members after a minimum discount has been set.
Lets say the minimum discount is set at Rs 5,000. This means the maximum amount any women can get from the total Rs 60,000 collected is Rs 55,000 (Rs 60,000 – Rs 5,000). After this discount bids are invited. All the women bid. One woman bids a discount of Rs 12,000. This is the highest discount that has been bid. And hence, she gets the money.
Since she has agreed on a discount of Rs 12,000, that would mean she would get Rs 48,000 (Rs 60,000 – Rs 12,000). She will also have to bear the organiser charges of around 5% or Rs 3,000 (5% of Rs 60,000). This means she would get Rs 45,000 (Rs 48,000 – Rs 3,000) after deducting the organiser charges.
The discount of Rs 12,000 is basically a profit that the group has made. This is distributed equally among the members, with each one of them getting Rs 1,000. This money that is distributed is referred to as a dividend. Of course the woman who got the money, will have to keep contributing Rs 5,000 every month for the remaining eleven months, like was the case with the kitty.
This is how chit funds works and they are perfectly legal if they are registered under the Chit Funds Act 1982, a central statute or various state-specific acts.
What if two or more women bid the maximum discount?
It is possible that two or more women in the group are equally desperate for the money and bid the highest discount of Rs 12,000. Who gets the money in this case? In this case there names can be written on chits of paper and one chit can be drawn from those chits. The woman whose name is on the chit drawn, gets the money.
Who do chit funds help?
A chit fundhelps those people who are facing a liquidity crunch and by bidding a higher discount amount they can hope to get the money being accumulated. So in the example taken above the woman gets Rs 45,000 by bidding the highest discount amount of Rs 12,000 and paying charges of Rs 3,000. But her contribution to the chit fund has been only Rs 5,000. So by effectively paying Rs 5,000, she has managed to raise Rs 45,000, which she can spend. Of course she will have to keep paying Rs 5,000 for the remaining eleven months. But by doing that the woman gives herself an opportunity to get a bulk amount once.
The chit fund company typically does not ask what the winner of the amount wants to do with the money. As Margadarsi Chit Fund, one of the largest chit funds in the country points out on its website “The purpose of drawing theprized amount need not be disclosed. It can be used for any need by the member for Example: House construction, Marriage, Education, Expansion of business, buy a Computer or any other purpose at his discretion.”
What kind of returns do chit funds give?
As is clear from the above example, chit funds the way they are structured cannot give fixed returns. The kind of return an individual participating in a chit fund gets depends on the maximum discount that is bid in each of the months. The higher the discount, greater is the dividend that is distributed among the members of the chit fund. In the example taken above the maximum discount bid was Rs 12,000. This meant Rs 1,000 dividend could be distributed among the women who were participating in the chit fund. If the maximum discount bid was Rs 6,000, then a dividend of only Rs 500 would have been distributed.
The returns also depend on the organiser charges. At 5%, the organiser of the chit fund in the example taken would get Rs 3,000 every month. At 3% he would have got Rs 1800 every month. Higher organiser charges mean that there is lesser money to distribute and hence lower returns.
While organiser charges are fixed in advance, the maximum winning discounts are likely to vary from month to month, depending the desperation of the individuals bidding. Given this, there is no way a participant in a chit fund can know in advance the kind of returns he can expect. The same stands true for the organiser of the chit fund as well, who cannot know in advance the kind of returns that a participant is likely to get.
Also even at the end of a chit fund, calculating returns is not easy. There are multiple cashflows. In the example taken above, every month there is an outflow of Rs 5,000 for every women who is a part of the chit fund. There is an inflow of dividend every month, which varies from month to month. One month in the year there is an inflow of the bulk amount that the woman wins because she bids the maximum discount in that month. To calculate the exact return, the internal rate of return formula needs to be used. It is difficult to execute this formula manually and needs access to a software like Excel.
Was Saradha a chit fund?
As we just saw a chit fund cannot declare in advance the return an individual is likely to make, given the way its structured. With Saradha chit fund and its promoter Sudipta Sen, that doesn’t seem to have been the case. Returns were promised to prospective investors in advance.
As an article in the Business Standard points out “Sen offered fixed deposits, recurring deposits and monthly income schemes. The returns promised were handsome. In fixed deposits, for instance, Sen promised to multiply the principal 1.5 times in two-and-a-half years, 2.5 times in 5 years and 4 times in 7 years. High-value depositors were told they would get a free trip to “Singapur”.”
If the principal multiplies four times in seven years it means a return of 22% per year. The question is how can such a high rate of return be promised, when bank fixed deposits are giving a return of 8-10% per year? Also, the fact that a rate of return was promised in advance clearly means that what Sen was running was not a chit fund.
This is proven again by a recent order brought out by the Securities and Exchange Board of India (Sebi) which is against the realty division of Saradha. As the order points out“The average return offered by the noticee (i.e. Saradha)…when the investor opts for returns were between 12% to 24%.” At the cost of repeating, a chit fund the way its structured cannot declare returns in advance.
So what was Saradha then?
The various investment schemes run by the various divisions of the so called Saradha chit fund, which were raising money from investors in West Bengal and other Eastern states, can be categorised under what Sebi calls a collective investment scheme. A collective investment scheme(CIS) is defined as “Any scheme or arrangement made or offered by any company under which the contributions, or payments made by the investors, are pooled and utilised with a view to receive profits, income, produce or property, and is managed on behalf of the investors is a CIS. Investors do not have day to day control over the management and operation of such scheme or arrangement.”
Lets take the case of the realty division of the Saradha chit fund which the Business Standard article referred to earlier says was “the company most active in collecting money from depositors.” Against the money collected Saradha promised allotment of land or a flat. The investors also had the option of getting their principal and the promised interest back at maturity.
The land or the flat was not allotted to investors and the investors did not have day to day control either over the scheme or over the flat or land for that matter. The money/land/flat came to them only at maturity. Given these reasons Saradha was actually a collective investment scheme as defined by Sebi and not a chit fund.
Where did all the money collected go?
This is a tricky question to answer. But some educated guesses can be made. If the Saradha group was collecting money and promising land or flats against that investment, it should still have those assets? Can’t these assets can be sold and some part of the money due to the people of West Bengal be returned? Media reports seem to suggest that all this was simply a sham and there are no real assets. Saradha was trying to create an illusion and was trying to tell its investors and its agents that this is what we are trying to do with the money we are collecting from you. But there was nothing really that it was doing.
The Business Standard quotes a Saradha group agents as follows : “We were bemused to see that only three or four people were working at the site which was being developed as a township. Sen said it would take 20 years to develop the projects as the company had so many businesses and it was not possible for him to oversee all of them,” says Abradeep, a Saradha agent.”
Agents were also frequently taken to Sen’s Global Motors factory which had stopped production in 2011. But when agents came visiting, around 150 people posed as workers in an operational motorcycle factory. If the money being raised from depositors was put to actual use, then flats would have been built and motorcycles made and sold.
All this leads this writer to believe that Saradha and Sen were simply rotating money. They were using money brought in by the newer investors to pay off the older investors whose investments had to be redeemed. At the same time they were creating an illusion of a business as well, which really did not exist.
In the end Sen had to ask his agents to rotate money as well. As the Business Standard points out “Depositors say Sen’s companies were prompt with payments in the first year. Trouble started in January when his employees didn’t get their salaries on time. Then agents were told to make payments for maturities with fresh collections or make adjustment against renewals.” This is what happens in any Ponzi scheme.
So where do chit funds fit into all of this?
Saradha chit fund is not a chit fund. And that seems to be the case with many other so called chit funds in West Bengal. A report in The Asian Age says that there are 73 chit funds running in West Bengal. The question is how many of these funds are genuine chit funds.
What seems to have happened is that a private deposit raising effort from the general public has been labelled as a chit fund. As Vinod Kothari writes in The Hindu “The West Bengal ‘chit funds’ are not chit funds at all, since these have a different structure. Chit funds are mutual credit groups where money circulates among the group members, and the monthly contributions of the chit members are received in rotation by one of the members who bids for it — much like a ‘kitty’…The several names that keep popping up in West Bengal are Collective Investment Schemes or Public Deposit Schemes.”
Most of these collective investment schemes or public deposit schemes do not have any business model in place. They simply rotate money using money brought in by later investors to pay off earlier investors. They also pay high commission to agents to keep bringing new investors. That keeps the Ponzi scheme going.
And as long as money brought in by later investors is greater than the money that has to be paid to earlier investors, these schemes keep running. The day this equation changes, these so called chit funds go bust. The same happened in case of Saradha chit fund as well.
The article originally appeared on www.firstpost.com on April 30, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)
Sudipta Sen, the man behind the Saradha group, who has been on the run, was finally arrested yesterday in the beautiful alpine valley of Sonamarg in Kashmir. Sen is accused of running a Rs 20,000 crore Ponzi scheme.
A Ponzi scheme is essentially a fraudulent investment scheme where money brought in by the newer investors is used to pay off the older investors. This creates an impression of a successful investment scheme. Of course, as long as money entering the scheme is greater than the money leaving it, all is well. The moment the situation is reversed, the scheme collapses.(For a more detailed and historical treatment of Ponzi schemes click here).
The scheme gets its name from an Italian American called Charles Ponzi who in 1919 ran an investment scheme in the city of Boston, which promised to double the investor’s investment in 90 days. This was later cut to 45 days. At its peak the scheme managed to collect around $40 million and had nearly 15,000 investors.
Ponzi thought he had figured out an arbitrage opportunity which would help him earn stupendous return. In the end he couldn’t execute the arbitrage and started using the money being brought in by newer investors to pay off the older investors whose money needed to be returned.
While every Ponzi scheme is different from another in its details, there are certain key characteristics that almost all Ponzi schemes tend to have. And Saradha was no exception to this.
The rate of return promised is high and is fixed at the time the investor enters the scheme: For an individual to get interested, the returns on offer in a Ponzi scheme need to be higher than the returns he can hope to earn from other modes of investment available at that point of time.
An order issued by the Securities and Exchange Board of India yesterday, explains this point beautifully. This order has asked Saradha Reality, one of the companies being run by the Saradha Group, to wind up operations in three months.
Saradha Reality catered to all kinds of investors. It had had instalment plans with tenure varying from 12 to 60 months where minimum investment was Rs 100 per month. It raised money from investors with contributions ranging from Rs 10,000 to Rs 1 lakh for a tenure of 15 months to 120 months. It also had a lump sum investment scheme (with minimum amount of 1000/- and multiple thereof) with tenure varying from 12 months to 168 months. The rates of interest on offer where different for different investment plans.
At the end of the tenure the investor had the option to get allotment of land or a flat or to simply get a refund of the money he or she had put in, along with the promised interest. And what were the returns on offer? As the Sebi order points out “The average return offered by the noticee (i.e. Saradha), in lieu of the land when the investor opts for returns were between 12% to 24%.”
So clearly the returns being offered by Saradha were higher than the returns on offer through other investment avenues. And most investors seem to have opted for the absolute return option rather than claiming land or a flat at the end of the investment tenure. As the Sebi order points out “As informed by the noticee (i.e. Saradha), not many of investors have opted for allotment of land rather, more investors have opted for the pre-determined returns as promised by it.”
The higher returns clearly got investors to invest in Saradha.
The most important part of a Ponzi Scheme is assuring the investor that their investment is safe.
How did an upstart like Saradha managed to assure investors that their investment would be safe? The story that seems to be coming out is that Saradha employed agents of Peerless General Finance and Investment Co. Ltd. Peerless, formed in 1932 had pioneered the collection of small savings in eastern India, primarily West Bengal. Hence, it had a reasonable reputation among the people of West Bengal.
As The Mint points out “Though it didn’t ever default on repayments, Reserve Bank of India (RBI) forced Peerless to stop taking deposits in 2005-2006. This spawned the growth of unregulated deposit-taking companies in West Bengal and other eastern Indian states.”
Agents of Peerless were used to collect money for the Saradha group. In that way the brand name of Peerless rubbed onto Saradha. The Mint story cited earlier talks about one Debasish Banerjee, who used to work for Peerless and then became the blue eyed boy of Sudipta Sen, and presided ove 10,000 sub-agents working across eight districts in West Bengal.
The instrument in which the scheme will invest appears to be a genuine investment opportunity but at the same time it is obscure enough, to prevent any scrutiny by the investors. If you go to the website of Saradha Group (http://saradhagroup.com/index.html) you will find that they were in multiple lines of business. From real estate to two wheelers to media to tours and travels to even bio gas. The company had presence across sectors. But where they doing any business? Largely, the answer is no. The various businesses were just used as a façade to collect money from investors. They were used to show investors and agents as to what the company was doing with the money it was collecting.
As the Sebi order points out in the context of the reality division “It was prima facie observed that under the scheme of the noticee(i.e. Saradha) the real objective is to mobilize fund from public by showing some real estate projects to the investors and the noticee indirectly promises return of funds with high interest rates.”
The company had even bought a two wheeler company called Global Motors to show off to its agents. As the Business Standard points out “The Hooghly factory of Global Motors, acquired by Saradha sometime back, had closed down in 2011. But 150 of its employees had been kept on rolls to show, when agents made visits, that all was hunky dory and operations were on in full swing.”
All this was enough to create an illusion that the company was putting the money it collected from its investors to some use. Turned out it was not. It was simply rotating money.
The period between the investment and the pay out in a Ponzi Scheme is short. This ensures that the word spreads fast and more money comes in. Every additional investor gives legitimacy to the Ponzi Scheme. As we can see in case of Saradha the minimum tenure on offer was around 12-15 months. While there is no conclusive proof to say that most investors opted for the minimum tenure or lower tenures, I feel it would be safe to say that most new investors who were checking out the scheme would have opted for lower tenures. And gradually as the scheme spread and got some legitimacy only then would the investment tenures have gone up.
Also the fact that the scheme has collapsed tells us at some level that not many investors opted for long investment tenures. If they had, money would still be coming in and Saradha would have managed to continue operations. The fact that its more or less shutdown tells us that money has clearly stopped coming in.
Brand building is an inherent part of a Ponzi Scheme. Sudipta Sen ensured that the Saradha Group had huge presence in the media. “His first entry into the space was through Channel 10 and thereafter he expanded into dailies—Bengal Post & Sakalbela—in 2010. Sen bought out Tara channels, as well. At the time of closing down, the group had 10 media outfits — news TV channels, newspapers and magazine,” the Business Standard points out. This gave the group a lot of credibility and helped build its brand. The cine actor Mithun Chakraborty was the brand ambassador for Channel 10.
Trinamool Congress was also seen to be close to the group. As Reba Mitra a Saradha agent told NDTV.com “We put our faith in Saradha because big leaders of the Trinamool, like Madan Mitra, Didi…the chief minister, Kunal Ghosh, Shatabdi Roy, Mithun Chakraborty – when these big people are with them, government people, then would this money be stolen from us?”
Julie Potua, another agent of Saradha told NDTV that “they told clients in their pitch that other companies could collapse but Saradha would not as “Kunal Ghosh is with us, Mamata didi is with us, so invest in us.”
Kunal Ghosh, was editor and chief executive of Saradha Group’s media business. He is also a member of the Rajya Sabha nominated by the Trinamool Congress. Shatabdi Roy is a Bengali actress who is also a Lok Sabha MP from the Trinamool Congress. Being seen close to the leading political party of the state was like the icing on the cake and attracted investors by the drove.
There are some indications being given now that the Reserve Bank of India had warned the state government on the mushrooming of chit funds in West Bengal.
What is interesting is that the SEBI has been investigating the Saradha Group since June 2010. The Saradha Group, like Sahara now, had managed to delay the process by submitting voluminous documents. At various points of time in 2012, Saradha submitted 16 cartons, 19 cartons, 170 boxes and 35 cartons, as a strategy to avoid submitting the specific information being asked for by SEBI.
After this Saradha Group was directed to provide information in excel sheets. This helped Sebi to nail the group. As the SEBI order points out “On sample study of the data (in excel) provided by the noticee (Saradha), veracity of which cannot be verified, it is noted that agreements for sale was entered into with two investors namely Dhruba Bose and Arindam Pani on January 01, 2010 for flats having number 1A and 1C, respectively, both admeasuring 1437 sq ft. area in the same building i.e., Ten Katha. It is further noted that the consideration amount for flat number 1A was Rs 37,69,000 and for flat number 1C was Rs 1,17,75,850. It is highly unlikely that in a real estate business the difference between consideration amounts for sale of two similar flats at the same building on the same day shall be in the ration of 1:4. In view of these facts the possible inference will be that the allotment of plots/flats are simply a farce, and might have been done to mislead the regulatory authority.”
But by the time the SEBI order came out, Saradha had already collapsed. What is intriguing is that the investigation against Saradha started in mid 2010, but it took the company more than two years to submit the relevant data. If SEBI had cracked the whip and acted a little faster, the situation might have been a little better.
The article originally appeared on www.firstpost.com on April 24, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)