Financial Fables on Rotating Savings

It is the end of a long night and five friends are sitting at a bar when the bill arrives. Everyone goes for their wallets but nobody seems to have the correct amount of change. One of the friends, the responsible one who always collects the money, grumbles about the weekly nuisance of spending ten minutes attempting to get the correct of amount of money from each member of the group. The least risk averse friend makes a novel suggestion, “The five of us spend a lot of time together, why don’t we just have one of us pay the bill each time? It will even out in the end.” The others give the suggestion some thought, and one chimes in, “Not a terrible idea, but how do decide who pays on each occasion?” Our daring friend who made the original suggestion, the Mohamed Younus of our clan, responds, “Why don’t we all just put our credit cards in a bag and let the waiter randomly choose? The laws of chance will make sure no one of us will end up taking to big a hit in the long run.” Amused but intrigued, the other 4 friends consider it and after deliberation and some pressure on the most cautious of the companions, the five friends agree to give it a try and call the soon to be bewildered waiter over to their table.

The five friends have just decided to play credit card roulette. Financial innovation at its finest (or at least its most crass and bourgeois). Time and hassle is saved, eventually it evens out and the gambling man gets a little bit of a thrill. On the negative side, I would note that this game could be harmful if one of the friends is afraid to admit that he is broke, and the game leads him to overdraft.

It is the end of a long day and five friends sit around playing cards in a village in Tamil Nadu. As they play, one of the men despondently speaks of how badly he needs to fix his roof, but how difficult it is to get a loan at a reasonable interest rate. For a busy man of his means, the idea of getting a low-interest loan from a state bank is a pipe dream. The high costs of using a moneylender is unappealing, as is spending the time in trainings and meetings one has to participate in to be a member of an MFI. His friends and family tell him that they wished they could lend him money, but the 3000 rupees he needs is more than they can spare.

Pondering this man’s problem, one of the other card players offers a suggestion, “My cousin told me that in his village, when one man needed money to pay for his daughters marriage he started a revolving fund. Basically, a group of 10 people each agree to put 500 rupees a month into a pot, they hold a lottery, and the winner gets to take home the money. But once you win, your name can’t be in the lottery next time. Also, the person who organizes the fund gets to take the first pot.” The others are intrigued, all of them could definitely use a lump sum of money for some purpose, and this might be a good way to force them to save. Skeptical but interested, one of the players asks how you make sure the winner does not just run away with the money. The answer comes that there are some risks, but if you don’t trust the other members, you don’t have to participate, and anyhow the amount of money in the pot is not so high that people would be able to run away and live off it. After further discussing the details, the five men agree to start a fund like this among themselves for 600 rupees a month, with the first 3,000 rupee pot going to man who needs to fix his roof.

The five friends have started a chit fund, as it is called in India or ROSCA as it is known internationally. Financial innovation at is finest.

As pointed out by Steven Klonner in his paper, “Understanding Chit Funds: Price Determination and the Role of Auction Formats in Rotating Savings and Credit Associations,” chit funds are a major part of the financial landscape in the developing world, but compared to microlending, they receive very little interest from academics or the media. To give an idea of the size of the market, Klonner highlights that in Tamil Nadu “the turnover in formal Roscas has been estimated at 100 billion Rupees, about 2.5 billion US dollars, in 2001.” Klonner also mentions that in 1980 in Central Africa, it was estimated that about 20% of all household savings were in informal ROSCAs. In the 1950s, famed anthropologist Clifford Geertz even wrote a paper on their importance in Indonesia.

You may have noticed that in the quotes above, I mentioned both informal and formal chit funds. This is because after originating informally (informal chit funds are still ubiquitous), chit funds have also become a large regulated business with chit companies taking a cut of each month’s pot, but also providing the service of collecting payment.

Another evolution that has occurred over the years will upset all of you clever arbitragers who read the Indian Development Blog (perhaps some of the out of work Lehman Brothers and Bear Sterns dealmakers now have time to check in) and must be drooling over the thought of starting chit funds in villages across India and living off of the interest. These days the majority of formal chit funds, and some informal ones, do not use a lottery to decide the month winner, but an auction instead. The person willing to pay the most for the month’s pot wins. Lets say the winner of a 10 person, 1,000 rupee a month chit fund offer bid 1,800 rupees to take the first months pot of 10,000 rupees. In this case she/he ends up taking home 8,200 rupees, but has to give 200 rupees back to each of the 9 other members. It is a bit complicated, but in the end those who take the earlier pots end up paying interest to those who wait for the last ones. In Klonner’s study the median “recipient of the first chit lends at an interest rate of 1.6% while the recipient of the last chit earns an interest of 0.7% per month.” See the paper for more details.

I don’t really know exactly what to make of chit funds and their role as a development tool, but since “Rosca members are mainly poor individuals who have little access to formal savings and credit markets because of high transaction costs and incomplete markets” it is clear to me that any financial product that is this successful and prevalent across countries must have lessons to teach us in what kind of products poor consumers want. Perhaps this tells us something about the importance of commitment saving or maybe it could be the basis of a tool that could be taught to SHGs to increase internal lending. Less likely, maybe it means that, like our credit card roulette playing friends, people simply enjoy a little risk and want something a bit more fun and exciting than a boring old joint liability loan.

For more info read this.