Improved Profitability, Transparency Equals “Bankability”

Erik Jens

As the diamond industry is considered “increased risk” by the banks and their regulators, lenders have reduced their financing of rough diamond purchases and expect diamantaires to improve their profitability and transparency levels. In a recent conversation with Martin Rapaport, Erik A. Jens, head of ABN Amro’s Diamond & Jewellery Clients, discusses the key issues governing diamond industry financing. Martin Rapaport: How do you perceive the market at the moment? Erik Jens: The mining companies are becoming more adaptive in their supply strategies and more demand driven maybe. That has to do with their capacity but also the fact that sightholders have realized that they cannot buy rough just for the sake of it and lose money in the process.    That’s a big change from the past few years and it’s in line with the banks’ calls for companies to focus on becoming more bankable and transparent.    In the old days, there was basically one rough diamond supplier. Prices were high, but everyone made money as there was a consistent flow of diamonds at a consistent price. That’s not the case anymore. It’s like the book by Spencer Johnson, Who Moved My Cheese.    The middle segment of the market has been able to restructure itself to some extent in order to buy rough from different sources. A manufacturer is going to get into trouble if it only purchases from one supplier because the goods have become less profitable. So they have to innovate in their purchase strategies, production cycle, efficiencies, etc.    Some companies have evolved and are able to be profitable by buying good qualities of rough at a good price from different sources such as the auctions and tenders and on the open market. However, others have not and they have to deal with the change that is taking place in the market in order to survive.    There is less volume being sold at the sights and diamantaires are more cautious about what they buy. Rough prices have come down a bit and diamantaires are taking care not to overstock their inventory. So the second half of 2015 could be better.    The biggest challenge facing the industry relates to consumer demand. I’m not convinced that current levels of demand are sufficient short-and mid-term. I’m concerned that the industry is being forced to cope with its own changes yet it also needs to have a stronger focus on the end consumer. MR: Is the issue that manufacturers had the discipline not to buy nonprofitable rough or have they simply run out of money? EJ: I don’t think they’ve run out of money. Some smaller companies have cash flow challenges — but that’s not abnormal in times of complicated market circumstances that we see now. However, we ask transparency of our clients in such a case, as we can understand and help them better to pull through. Diamantaires are being more cautious because they’re starting to understand that they need to improve their bankability, which means that they realize that they need to be more profitable and transparent.    There is also a new generation of diamantaires that conduct business in a more modern and corporate manner. The older generation works according to a handshake, which is not conducive to today’s regulatory requirements, although the fact is a handshake and trust are still key ingredients in doing business in modern times.    In addition, diamantaires are more cautious about how they buy because the banks require that they put more of their own skin in the game. MR: ABN Amro was among the first to shrink its credit lines to finance 70 percent of rough purchases from 2014. What effect did that decision have on the market? EJ: It didn’t have a longer-term impact, indeed, but it did not have any abrupt effects. It may have even helped lower rough prices. Our clients reduced their purchases and became more robust by deleveraging the balance sheet.    The policy is in place and we’re absolutely not going to raise our advanced rates. If anything, we may further reduce our financing of rough purchases for trading purposes. We don’t have concrete plans but this has been discussed because trading is more speculative than manufacturing.    We also need to diversify the way financing is made available to different clients. We want to reward the more corporate clients who have the right structure and transparency, good governance and who meet International Financial Reporting Standards (IFRS). We want to motivate clients to be more corporate-like or leave the bank. MR: Does the lack of liquidity in the market stem from banks reducing their available credit to the industry? EJ: I don’t believe there is a lack of liquidity. I think there is a challenge in certain areas of the market and in certain locations. But there is liquidity available for good companies.    A lot of companies have moved into a specialized niche or reinvented themselves to be profitable. There are still too many companies that only think about top-line turnover, instead of bottom-line profits. The banks are expected to support them based on turnover but that’s not the way it works anymore.    The banks are willing to grow step by step, so I don’t think there’s a liquidity crisis in Israel, Hong Kong, New York, Dubai or Africa.    We have a bit of a challenge in India, where there is a high percentage of nonperforming assets. The regulators are looking at this very closely and asking if these banks are doing the right thing. We also see in Belgium the impact of Antwerp Diamond Bank (ADB) closing, but that also creates opportunities for other banks we see coming in there as well.    So if you run a business that is profitable, transparent and has the right structures, the banks will be willing to finance you.    The question arises why such a large portion of industry financing is concentrated on the middle of the distribution chain. The miners get paid in cash ten days in advance, and don’t give credit to their buyers. Retailers have a lot of inventory on consignment and they buy with 120 days credit. So the problem is not so much overall credit, but the way that financing is distributed throughout the pipeline. MR: Is the industry over-financed? EJ: I think the industry could do with less by making sure that people lower their leverage and that they put more of their own money in.    Some of our larger clients have been deleveraging, reducing their balance sheets and lowering their volumes. And they have become more profitable than they were previously. That’s exactly what we want from them. We ask them to focus on profitability and not on turnover. And again, as trusted partner to our clients, we are willing to help them where needed in this process. We are still a service industry to the sector with a client-centric approach. A recent survey we did among all our clients shows that on average our clients do appreciate the reform of the industry we try to accomplish with all stakeholders like our clients, but also the Antwerp World Diamond Centre (AWDC), the World Federation of Diamond Bourses (WFDB), The World Jewellery Confederation (CIBJO), the Gem and Jewellery Export Promotion Council (GJEPC), Dubai Multi Commodities Centre (DMCC) and many others.    The banks are willing to support the industry, but they are also short on capital and have to comply with new regulations. So the industry needs to think about other structures, like special purpose vehicles (SPVs), or bring in investors or vehicles such as credit insurance. There are solutions beyond the banks and there should be a shift toward more asset-based secured lending. MR: Is there any danger of companies going bankrupt because the banks are restraining credit, or because banks such as ADB and Bank Leumi are pulling out? EJ: I don’t think so, because ADB is scaling down step-by-step, giving its clients plenty of time to refinance with other banks.    What we do see is individual companies lose touch, or have only one way of doing things and subsequently run into cash flow problems — especially as profitability has diminished. Generally, these companies repay the market first and then the banks, and that affects the trust that the banks have in the industry. There are a lot of good, big companies that are willing to change but there are a few that are ruining the overall atmosphere.    Also, we’re servicing an industry about which the regulators — be it governments, the central banks or the Financial Action Task Force (FATF) — have real concerns.    Despite all the good things that the industry has done, many — including the regulators — still associate the industry with issues such as blood diamonds, smuggling, terror financing, tax evasion or bad labor practices.    Therefore, the diamond industry is rated as “increased risk” by the regulators, which means that businesses have to carry more capital and do additional reporting. So it’s more expensive to finance a diamond company than, for example, a real estate, agriculture or health care company.    As said, we appreciate and support the many initiatives taken to remedy this situation, for instance by the World Diamond Council (WDC), the WFDB and other stakeholders. But you have to ask if it’s enough, because the regulators feel there is still a lot to do.    The industry talks a lot about the need for generic marketing but it should also think in terms of rebranding the industry to improve the perceptions of the banks.    The diamond industry has to move away from that negative brand and toward being part of the jewelry and luxury industries. Doing so and improving its reputation and reporting standards would help negate the perception that the industry is increased risk. MR: What are the banks looking for when assessing their diamond clients? EJ: First, we want to gain a good understanding of the company’s goals, mission and strategy. We also want to understand its ethics in terms of corporate and social responsibility.    Then we go a bit deeper to understand how the company is structured and financed. We look at aspects such as who are the ultimate identified beneficial owners.    We look at the financials, the makeup of its equity and the company’s ratios. Cash flows are important because businesses with cash flow problems tend to face discontinuity. Profitability is very important to our assessment but we also understand that there are periods that are less profitable or nonprofitable. We pay strong attention to inventory levels and valuations.    We also look at the people involved in the company. It’s okay if the business is made up of family members but we like to see, for example, an independent finance department and chief financial officer (CFO) and we also take into account who are the auditors.    The more transparent the company, the better credit rating it will have. MR: Are these measures a result of new regulations governing the banking sector in general? EJ: Our de-risking exercise was initially meant to further control our diamond portfolio. It was also a matter of regaining trust and understanding the reputation of the industry.    However, we were also faced with other constraints. There are new ways for banks to allocate capital as a result of tougher restrictions. The cost of banking has gone up dramatically, especially when you consider the regulations and standards required of banks. The banks and the regulators need to know more from their diamond clients than they do from clients in most other sectors because diamond clients are ranked as “increased risk,” as mentioned earlier. MR: How do you assess risk and what affect does risk have on your book? EJ: There are different types of risk that a bank faces regarding a client: operational risk, credit risk, market risk and reputational risk, and there are different models that calculate those risks. Risk is applied as a percentage of a bank’s outstanding credit and it is then assessed by how well a bank is capitalized. MR: What is your estimate of global bank credit to the diamond industry? EJ: Financing rough diamond purchases has reduced from $15 billion to about $13 billion. I expect that about $4 billion to $5 billion is provided to India and the rest is spread across other centers.    It’s more difficult to assess the extent of credit for polished and jewelry manufacturing because a lot of that lending is being done via the more corporate banks and not through the diamond banking units. The major jewelry manufacturers and retailers, such as Signet and Chow Tai Fook, also have more corporate structures, so it’s difficult to tell.    The total value of the diamond and jewelry business is around $75 billion, so the value creation from diamond and jewelry manufacturing is about $60 billion. But I don’t know the extent of the bank financing there. MR: What would happen if interest rates go up? EJ: Initially there would be a bit of a buffer, since the banks earn a relatively high margin from what they charge the industry. We’ve seen our credit lines going down gradually in the past few months, so people are getting smarter. They will make their calculations with higher rates and decide to either leave goods on the table or slow down their operations or find a different way of financing.    That’s a normal functioning of the market that becomes more difficult to navigate as interest rates go up and volatility rises. MR: Do you expect rough prices to drop given the weak polished market and the unsustainable correlation between the rough and the polished? EJ: I think that rough prices will come down, but not by much because the miners look at their profitability and have their own cash flow challenges. De Beers and ALROSA also have corporate strategies to consider.    The correction should be gradual, as a sharp price decline on rough or polished affects inventory and valuations. So I think we’ll see a bit of a correction on the rough and we’ve already seen a correction on the polished. MR: The problem is if the business becomes profitable again, will the Indian banks rush in with more credit and put fuel on the fire, which is how we got into this mess in the first place? EJ: Everyone has a responsibility. India is a very diverse market with about 60 banks active in the industry. Indian regulators have expressed concern about the high level of nonperforming assets in the diamond and jewelry sector.    But I believe there is a concerted effort by the Reserve Bank of India and support from GJEPC to improve the situation. They don’t want a banking crisis in India. Both the banks and our clients there are also realizing that things have to change and that the industry has to deleverage. MR: What are your expectations for the industry for the remainder of 2015? EJ: Hopefully demand will pick up. We don’t expect double-digit growth, but there will be some improvement and that will help reduce polished inventory levels. I think people will have to create more of their own niches and specialties to be profitable. I hope that rough prices will come down, but not too fast, so that manufacturers will gain better profits on rough.    In the lending environment, I think we will see some players reducing their lending and new players coming in. Bank credit is not going to grow fast, but I don’t think there’s a need for credit to increase. I have a relatively good feeling about the banking environment, but if you don’t know what you’re doing, you’ll get your fingers burnt, as in any other industry sector.