Rapaport Magazine

Credit Crunch

Banking experts say the industry must clean up its act if credit is to remain available to the midstream players.

By Shuan Sim

In 2014, the diamond industry took a big hit to its financing options as the Antwerp Diamond Bank, with a portfolio of about $1.5 billion, which had Belgium’s diamond business for over 80 years, decided to call it quits. In that same year, Israel’s Bank Leumi pulled out of lending to the U.S. diamond jewelry midstream. From 2015 on, more banks have either scaled back their exposure to the diamond industry or completely washed their hands of it, with the most recent being Standard Chartered, which ended its diamond financing arm worth about $2 billion in June 2016.
   Ronnie VanderLinden, president of New York City diamond cutting firm Diamex and president of the Diamond Manufacturers & Importers Association of America (DMIA), describes Bank Leumi’s departure from the U.S. as a shock. “I had my bank accounts there for over 20 years, and suddenly we were spoon-fed off to other banks. I thought we were ‘Teflon-coated’ here,” he says. Global consultancy Bain & Company, Inc. described the declining liquidity as one of the most urgent challenges facing the industry in its “Global Diamond Report 2014.”

Then and Now
   Debt by the diamond midstream has grown precipitously in the past ten years, according to Erik Jens, head of diamond and jewelry clients at ABN AMRO. “Debt on rough trade and manufacturing grew from about $5 billion in 2000 to $15 billion in 2014, but we didn’t see the prices of diamonds and/or volumes triple during those years, so where did the money go?” he asks (see Debt-Polished Diamond Value Ratio chart in slideshow).
   Following the significant deleveraging of the industry, Jens estimates there to be about $12 billion of credit owned by the diamond midstream. “That process was helped by a market slowdown, led especially by the Chinese economy, as well as reduction of inventory,” he says. “Central banks around the world imposed tighter regulations on lending institutions, affecting banks’ diamond lending arms as they are categorized as ‘increased risk,’ resulting in higher capital and reporting requirements,” he elaborates.
   Some banks financing the industry were in the meantime dealing with their own derisking and deleveraging processes, which led to reduction of their overall portfolio or even a full withdrawal in certain industries, including diamonds. “For some of them the size of their diamond portfolio was simply not big enough nor worth the trouble to keep lending to the industry,” Jens notes. He describes ABN AMRO’s approach — the bank reduced its portfolio by, for instance, reducing advance rates as well as a loan’s maturity period. In return, ABN AMRO invested in sustainability and responsible sourcing. “De facto, this is not long-term financing but short-term revolving self-liquidating credit when we talk about receivables finance.”
   Des Kilalea, U.K.-based analyst at investment bank RBC Capital Markets Europe Limited, explains that the shrinking advances followed banks questioning receivables as collateral. “Diamonds are often sold on memo, or credit, and some banks don’t want to fund that.” According to Kilalea, “Banks are asking more and more, ‘How good are these receivables? Are they actually salable?’”
   However, not all diamond-trading regions are equally hit by the credit squeeze. “There is enough liquidity out there. We worked a lot with other banks to introduce them to the industry and quite successfully in Dubai in particular,” comments Jens. He added that while there could be a temporary shortage in Belgium now due to deleveraging, the industry is healthier now in that region, especially with the new Carat Tax legislation. The U.S. is less affected, as only 20 percent to 30 percent of midstream financing comes from banks, Jens highlights, as compared to Europe, where up to 70 percent of loans comes from banks. “The U.S. has a very strong private financing industry. In Europe, it is not as strong as in the U.S. and U.K. but it is growing,” he elaborates.
Explaining the Pullback
   “There’s too much indebtedness in the midstream,” says Kilalea. “There were too many potential bad risks for banks, some of which materialized.” Following the 2008 recession, banks needed diamond clients to demonstrate a stronger practice of what is commonly known as “KYC” — know your customer. “Banks want to know where the diamonds are coming from and where the money lent would be going,” Kilalea points out. “Most of the midstream have good business practices, but many are still informal in the way they carry out business. The diamond industry’s creditworthiness is just not there as a whole,” he says.
   The tightening of lending terms is not unique to the diamond industry — it affects all forms of lending. “Regulations have been getting stricter over time. Banks have had to reserve more capital against riskier business,” Kilalea says.
   The tightened restrictions have caught some diamond businesses by surprise, suddenly depriving them of financing. “I think it’s awful what the banks are doing to the industry,” says VanderLinden. In addition to the banks pulling out, VanderLinden feels that the increased legislation on compliance on diamond imports has made securing loans harder. “It seems to be a compliance and transparency issue. A large diamond company could be legitimate, but because it didn’t do something properly by the books, it could be penalized,” he says. VanderLinden points out that the heightened compliance requirements of the Kimberley Process (KP) and Patriot Act, while helpful for cleaning up the industry, have been implemented without many in the industry fully understanding what is required of them. “We don’t know how much more accountable we can be,” he says. “What more do they want? We are trying to do everything that’s possible, but if we’re tied down by paperwork, we can’t do anything.”

Midstream Solutions
   In the new lending climate, banks wish to see their clients fulfill certain criteria before handing over the loans.

Increased Transparency: According to Kilalea, many companies have lost their financing and closed down, especially in India, because their accounting was not up to required standards. “There are a lot more small companies in India and their accounting might not be as sound as a De Beers or ALROSA sightholder,” he notes.

   Jens explains that banks want their diamond clients to work with robust accountants and to have a clear corporate structure. “Essentially, be a normal corporation. Run your corporation as a normal business with normal accounting. He feels that the industry is still affected and adjusting from the De Beers dominance in the past to an open market functioning, where rough prices are set by demand and not by supply.

More Profitability: “The industry needs to make more money and they need to have more non-borrowed capital,” Kilalea says. Profitability in the diamond midstream was a problem in 2014 when rough was too expensive and diamond producers were convincing manufacturers to buy rough that they shouldn’t at a time when polished prices were depressed, he explained.
   At the same time, diamond manufacturers were running big overhead costs over the past 15 years, as they were building factories that were too big. “Diamantaires were encouraged to build factories to manufacture everything on their own when they could have outsourced to third parties. They did not need to do everything, from cutting to smelting,” Kilalea points out. “The diamantaires’ strength was in buying rough and selling polished, not running factories.”

Clear Strategies: Banks want to see what a borrower’s growth and sustainability plans are, as well as plans for corporate social responsibility and maintaining a competitive edge, Jens says. “Banks will want to know what is a company’s five-year plan and investment plans. What the next generation of the company is going to do. How they obtain their goods, rather then just sights at any price, varying from open market trade, tenders and auctions,” he elaborates. As part of the improved KYC requirements, Jens adds that banks want to know if diamantaires have the right sourcing protocols, if the diamonds are traceable or compliant with international legal standards.
   VanderLinden highlights that in the U.S., connections in the banking industry have been engaged to help the diamond midstream formulate these strategies that banks are looking for. “They are telling us what we need to do as an industry. Be it the KP, or the Responsible Jewellery Council (RJC) or any other different protocols, we’re doing our best to make it easier for dealers and manufacturers out there to comply with all of them,” he says.

The Near Future of Lending
   Some companies will find it difficult to obtain the needed financing if they are unable to meet the banks’ requirements. “If they can’t take the heat, they need to get out of the kitchen,” Kilalea says. It is likely that diamond companies will turn to alternate forms of financing, remarks Jens. The future of financing would likely include the shadow banking by nonbanks, pooled investors and special purpose vehicles (SPV), a legal entity created for the purpose of managing assets, he adds.
   “Some companies will go out of business, others will merge. The lending situation will bottom out over the next couple of years,” Jens says. Kilalea agrees with that sentiment. “From a manufacturing point of view, it will be more of a big players’ game, but there will be room for small, innovative guys who are efficient and creative in the industry.”
   “The overall industry is adjusting from a supply-driven pricing system to one led by demand,” Jens concludes. “We’re in the midst of a perfect storm that will take a few years, where we will see good businesses come through and bad businesses and practices be weeded out.”

Article from the Rapaport Magazine - November 2016. To subscribe click here.

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