The government has announced a bailout package for the participants of unregulated saving schemes that have been put at risk by the current Chit fund crisis in West Bengal. In this article, Banerjee and Ghatak caution against putting deposit-takers and micro-lenders in the same bracket while considering stricter financial regulation to prevent recurrence of such events.

The current crisis in the financial sector in West Bengal has put millions of small savers, many of them quite poor, at great risk. The government has reacted by announcing a bailout package for participants of these “chit funds” or unregulated savings schemes, which it can ill afford, especially given that it is cutting back on other development expenditures.

However, this is standard practice for governments in India and abroad. Victims of failing banks and other financial firms are often bailed out even if they were guilty of taking on bad risks out of greed. In a world where big banks or financial institutions often get away with murder because they are “too big to fail”, it might be a bit unfair if these investors are viewed as “too small to be worth saving”. It is true that two wrongs don’t make a right, and one should be aware of the negative incentive effects of bailouts of any kind. However, given the widespread practice of ad hoc compensation to any group that has been victimised, we feel that the present case may not be the right one to take a tough stand.

The Chit Fund crisis: Background

West Bengal stands out in terms of supply of small savings with respect to the rest of India, both relative to its population and state domestic product. In 2011, its share of population was around 7.5% and its state domestic product was 6.7% of national Gross Domestic Product (GDP), but its share of bank deposits was 22%. In addition, a recent survey in the state found that almost 40% of the respondents felt that their income is not high enough income to open a bank account — banks seem unwilling to serve this population, probably because the deposit amounts tend to be small. For those who do have an account, real interest rates have fallen sharply in recent years. It is the pent up demand of these small savers for a rewarding place to keep their money that has created a happy hunting ground for unscrupulous financial organisations promising very high returns, like the ones presently under investigation.

Thinking beyond compensation and crisis management

The really big issue therefore is how the state should think beyond compensation and crisis management, and react to prevent a recurrence of such events. Most of the 87 financial institutions currently under investigation are based in West Bengal, which shows the extent of the problem, and the urgency of stepping up regulatory effort. The obvious step is very strict regulation of any institution that takes deposits. There needs to be a very clear certificate of "quality" that is widely publicised and recognised, and announcements that there will be no bailouts of people who invest in uncertified institutions. This needs to be backed up by publicly linking this process to some credible and apolitical certifying body like the Securities and Exchange Board of India (SEBI) or Reserve Bank of India (RBI), and financial literacy campaigns that warn people of the danger of being allured by impossibly high returns. A more long term issue is how to facilitate small savers access to reliable banking services, and here innovative methods such as mobile banking should be tried out.

Should not put all financial intermediaries in the same bracket

In framing these regulations it is very important that we recognise that deposit taking institutions are fundamentally different from lenders, reflecting the basic difference between borrowing and savings in terms of who is exposed to the risk of default. In particular, in West Bengal and elsewhere in India, commercial micro-lenders have been playing an increasing important role in helping low income borrowers get better access to relatively inexpensive credit that they use to finance weddings and consumer durable goods, as well as a certain amount of business expansion. The danger is that in the current climate of hysteria against financial institutions, there may somehow be a rebound on to these micro-lenders.

That would be both unfair and undesirable. Commercial micro-lenders are essentially not allowed to collect savings from inpiduals and therefore they cannot start a Ponzi scheme. They may create other problems such as over lending or pressuring borrowers who have fallen behind in repayment - as in the recent crisis in Andhra Pradesh. But these are very different kinds of problems and require very different type of regulation. In particular, lenders do pay a large cost when they over-lend because they often end up losing the money they had lent. In addition in this post Andhra Pradesh climate, every micro-lender knows the disastrous consequences of being too greedy or pushy. They are already inclined to play it safe. Moreover, a new set of nation-wide regulations for the microfinance industry are already in the offing.

Small savers should not suffer

The main point is that the low-income customers of the microfinance industry should not be made to pay for the sins of unscrupulous deposit-takers. That would be collateral damage in more senses than one.

A version of this article appeared in the Anandabazar Patrika.