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Geographic Distribution
In urban areas of Tamilnadu, Karnataka, Andhra Pradesh and Kerala 5 to 10% of households participate in registered chit funds.
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 (KSFE) 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.
Karnataka Govt Too runs a Chit Fund Company named MSIL and its very popular.
How it works
A chit fund comprises a group of members, called subscribers. An organizer, a company or a trusted relative or neighbour, 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 instalments 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 instalment is Rs 1000 and there are 50 members, the pot in the first month will contain Rs 50,000. If the auction determines a winner who is willing to pay $45,000 for that month, the surplus Rs 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 Rs 45,000 in the first month and the others benefited in their share of the Rs 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 instalments.
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.)
Risk
Both organizers and subscribers in chit funds are exposed to credit risk because subscribers might default on their periodic payments.[1] 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, the system is a riskier method of saving than using a bank savings account.
Legal framework
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:
"Chit means a transaction whether called chit, chit fund, chitty, kuree or by any other name by or under which a person enters into an agreement with a specified number of persons that every one of them shall subscribe a certain sum of money (or a certain quantity of grain instead) by way of periodical instalments over a definite period and that each such subscriber shall, in his turn, as determined by lot or by auction or by tender or in such other manner as may be specified in the chit agreement, be entitled to the prize amount".