Pyramid Schemes: A Wake up Call for Banks

Published on 3rd July 2007

It is a fact that ponzi and pyramid systems are popular to investors expecting huge returns on their money in a short period. Unlike the financial institutions regulated by the central bank, deposits in a pyramid entail minimal operation costs and promises of a 300 percent interest in less than five months. When the deal is too good however, one ought to think twice.

Development entrepreneurship community initiative (DECI) is one such institution in Kenya that collects money and uses the deposit to pay attractive returns to members after a specified time, usually two to five months. The rate of emergence of such investments within a very short period raises eyebrows.

The central bank, responsible for controlling the operations of financial institutions has declared pyramid schemes illegal for unlike registered financial institutions, pyramid schemes are not protected by the deposit protection fund should they collapse. The investor is therefore not guaranteed any compensation, hence increased risk on hard earned finances.

Despite the public outcry of unfulfilled promises and warning from the central bank, pyramid schemes, some of which were founded by former directors of collapsed credit institutions continue to attract a large number of new entrants. Members of such schemes claim that the conditionalities in mainstream banks such as charging of high interest rates, dishing small interest on savings and ignoring people in the low income cadre have led to the creation of pyramid schemes. It is therefore not surprising to see depositors withdrawing money from their bank accounts and rushing to invest it in high risk financial institutions where quick and easy returns are promised. Commercial banks have thus borne the brunt of limited credit and bad loans resulting from loans used to finance pyramid systems.

The central bank needs to rethink measures to control the spread of such schemes. One such measure would be setting a floor rate for interest on deposits to make savings more attractive and limit other charges levied on account holders. Such a measure will encourage the growth in customer deposits and enhance credit creation power by commercial banks. Financial institutions will reap bigger returns from economies of scale and depositors will be guaranteed fair returns. Another measure would be public enlightment on the need to do thorough research before making investment decisions. 

The central bank could also maximize on the entrepreneurship abilities of owners of the pyramid schemes by ensuring that they operate within the required legal framework in a win- win situation.

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