“A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain.” This was the historical wisdom of Mark Twain. Twain has been dead for almost a century, but many – or at least some of us – are still convinced that Twain succinctly, accurately, and almost like a visionary, pictured the essence of a “banker” in one simple sentence. This crossed my mind when thinking that we as trade press, or maybe as industry at large, may not have sufficiently been following the changes in the banking system – the ways our bankers think and make decisions. We analyze the supply system of rough diamonds and try to double-guess what De Beers, Alrosa, BHP Billiton, Endiama, and Rio Tinto may be planning and how it will impact us. We are in tune with compliance issues from Kimberley to Best Practice Principles to Anti-Money Laundering.

            Basel I concentrated on the capital adequacy requirements solely in terms of credit risks. With some variations, by and large a bank needed to have 8 percent equity on its lending portfolio. Under Basel I there was no differentiation (in terms of capital adequacy requirements) if the borrower was a diamantaire, a shoe-manufacturer, or a used-car dealer. Then came Basel II, which dramatically expanded the scope of Basel I. In terms of credit risks, there will now be differentiation between various groups of borrowers for capital adequacy requirements. So if it is decided that diamonds and jewelry represent a higher risk than other sectors, a bank may be required to maintain a higher level of capital. This will affect the interest rates that the industry pays, but, more importantly, whether it is worthwhile for a bank to be involved in diamond financing from a capital adequacy perspective.

            Basel II does something else: it now also imposes capital adequacy rules on operational risks and market risks. This is new – and requires banks to dramatically reform the way they do business, which is the reason for a prolonged implementation mechanism to 2008 or beyond.

            Have we asked ourselves, for one moment, how Basel II will affect the policies of the diamond bankers? How many of us are aware of the fact that our bankers are spending fortunes in devising “industry profiles” and “industry models” to guide their policies in the diamond industry?

            When a large retailer is denied his traditional credit line, we may jump to the conclusion that the bank may consider the client a credit risk. That may be – but it also may not. Bankers have become totally preoccupied with operational risks, with reputation risks, and with other risks that have nothing to do with the commercial risks.

            If we look at the hundreds of millions of dollars of penalties levied by banking authorities on the banks that also finance the industry, these penalties were not related to malfeasance or fraud – they were solely related to management control systems, or the lack of controls.

            In Belgium, we have seen a bank that decided to get out of financing the industry. Do we know what triggered the move out of the diamond-financing business? Has anyone asked the bank?

Systems versus People

            Most diamond industry borrowers tend to believe that decisions are made at the level of diamond branches or slightly above; has Basel II changed that? Has the branch manager become a nice face – or nice window and are decisions gradually becoming computer outputs, just like Sightholder appointments at the DTC?

            When De Beers changed its business model, it wanted the industry to move from a supply-controlled system to a demand-driven environment. We all took notice and tried to find ways to carve a niche in this transformed environment. However, around the same time, the world’s international banks changed the outlook and vision of their business. Banks have become pre-occupied with the management of operational risks – the risks of loss from inadequate internal processes or failed internal control.

            With “processes” they mean people, tools, methods, procedures, or systems. As banks are growing and growing, just as companies, the operational risks controls are also evolving – and, as management guru Peter Drucker explained, “The evolving organizational structure will resemble an orchestra with 300 professionals and one conductor.” An orchestra doesn’t have sub-conductors, in the way industrial and financial organizations are presently built. It has, at best, a first-violin, a top professional who distinguishes himself by being a virtuoso – and who is part of the operational risk landscape.

            Many problems in large companies (banks, manufacturers, etc.) are that companies have too many virtuosi poorly controlled by their respective boards of directors. Therefore, just as diamantaires are figuring out how to deal with structural changes within our industry, banks are doing the same within the banking community. There is a distinct shift from preoccupation with credit risk and market risk issues to operational risks.

            When banks recognize volatility in a major client’s cash flow – and they signal a big cash flow shortfall – this is now immediately taken as a sign that the same thing could happen to others. This is not seen as a “commercial risk” anymore – but as an operational risk – it can put the institutions at risk.

            Truly, one might argue, this has very little to do with the diamond and diamond jewelry industries. Not so. As an industry, the diamond and jewelry industries are far more complicated and “risky” for the banks from an operational risk level – the commercial risks aren’t the main issues at the moment. Commercial risks are, by and large, well under control. Banks are not complaining about that, and the business failures in the diamond sector (worldwide) are minimal in comparison to volumes of debt.

            The lines between “operational controls” and “credit risks” are not always clear. When a large diamond jewelry retailer defaults, the financial loss incurred by the bank is one thing – but now the operational issues are becoming far and far more important. Why didn’t we have an early warning system? How come that we failed to see this coming? Have we relied too much on the bank manager? Basel II forces the banks to look at such processes.

            Banks are extremely worried about the operational risks and they are developing “models” on how to rate the industry: what are the parameters to monitor sector risks, how to quantify those risks, and whether involvement in or exposure to a sector is justified from an operational risk aspect? Go to a traditional diamond branch: the turnover in people seems to be far lower than in other branches, which is justified because there are special skills needed to serve the sector. This is, however, an operational risk to the bank. And there are many more examples.

            This column doesn’t want to get into the issues of banking management – we are hardly competent to do so. But our office gets many inquiries from banks – and we are probably not the only one – which shows that the industry is being analyzed by three different groups within the banking community: (1) the traditional officers looking at credit risks; (2) a whole new group of officers looking at the compliance risks – a customer with an excellent credit rating may still pose an enormous compliance risk to the bank; and (3) another group of people looking at the diamond industry (which is by nature a cross-border transaction industry) from a Basel II perspective.

            The output data from these three groups are used to build models – and these models increasing guide the decisions of the sub-conductors (the middle management), who today are more than ever forced to follow inflexible rules.           

Basel II (which is a term that refers to the International Convergence of Capital Measurement and Capital Standards - A Revised Framework) is basically a set of recommendations by bank supervisors and central bankers from 13 countries (making up the Basel Committee on Banking Supervision) to revise the international standards for measuring the adequacy of a bank's capital. It was created to promote greater consistency in the way banks and banking regulators approach risk management across national borders.           

            In a way, Basel II is comparable to the Kimberley Process or the OECD’s Financial Action Task Force. The Basel Committee provides a forum for regular cooperation on banking supervisory matters. Over recent years, it has developed increasingly into a standard-setting body on all aspects of banking supervision, including the Basel II regulatory capital framework. The Committee's members come from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, United Kingdom, and the United States. (Countries are generally represented by their central bank and also by the authority with formal responsibility for the prudential supervision of banking business where this is not the central bank.)

            Basel II uses a "three pillars" concept - (1) minimum capital requirements; (2) supervisory review; and (3) market discipline – to promote greater stability in the financial system.

            How could that affect us? Take a company that utilizes 70 percent of $25 million credit line. Against every dollar extended to a client, the bank incurs a capital cost. For money not extended (but available to the client) there may be no costs or a minimal cost. However, says Basel II, when a customer who normally uses only 70 percent of his credit facility suddenly uses 80 percent or 90 percent, that money becomes high-risk money. If everything was “business as normal,” the client wouldn't need that extra money.

            So new rules will come in place to see how that “non-utilized” capital can be safeguarded. This may also apply to doctors, groceries, and architects. But in the diamond industry, trade practices require the possibility to buy, occasionally, some extra specials; to buy more rough; to maintain higher inventories, etc. The need to have a greater credit facility than is actually needed for day-today-operation is very specific to the diamond industry. Under Basel II, this may become costly – and diamantaires may need to pay for non-utilized credit lines.

Requirements for Transparency and Accountability

            To reduce operational risks (not just credit risks), the banks will be required to have a much deeper understanding of the various sectors they are involved in and they will need much more information from clients. You can be a no-risk or low-risk client, but still the bank may prefer not to have you as customer for operational risks reasons.

            Moreover, these new risk control systems are costly. Clients have to pay for that. We’ll increasingly see situations where small or medium sizes clients will be asked to “go elsewhere” if the increased costs involved reduce the profitability of the client.

            The opaque, non-transparent nature of the diamond industry would have become a major issue under Basel II and bankers tell us that the transformation taking place in the diamond industry will enable the continued support for the sector. One Belgian banker actually expressed a fear that “the industry transformation may not go fast enough from a Basel II perspective.” Diamond financing is viewed as asset-based lending. That means that banks must understand the uses of the money, they must understand the underlying transaction. That requires transparency. In the past, money might have been given based on sound collateral. That is not enough anymore – under Basel II the bank needs to know why and for what does the borrower need money.

            Basel II models will contain more rigid rules on business cycles – and time horizons. This means that during a downturn in a sector’s business cycle, banks would need to reduce lending – as most of the models would forecast increased losses. To return to Mark Twain: such banking behavior will simply increase the magnitude of the downturn.

            Are we on the eve of such development? I don’t know. How will Basel II affect us? I don’t know either – because Basel has hardly been on our radar screen – and banks mainly view this as an internal issue of no concern to clients. We don’t see it that way – clients ought to understand the decision making process of their bankers.

            Words like: Kimberley, London, Brussels, Dubai, Antwerp, FinCEN, European Third Directive on Money Laundering, FATF, Diamond Best Practices – they all have certain connotations in our trade dictionary and vocabulary. Basel II isn’t on that list – not yet.

            FATF contains recommendations to banks on anti-money laundering and anti-terrorist financing. Basel II contains recommendations on operational risks – and banks are now looking intensely at the industry through a Basel II lens. We think that we must start to understand “what” the banks are looking at – and what it might mean to us. Diamond banks ought to make greater efforts to make the industry understand what “they are looking for” – there is no conflict, at least not on a macro-level.

            Some bankers have confided that, based on the work done so far, there may be fewer ramifications on diamond industry financing then had initially been feared. This is a good sign. Mark Twain, if he were alive today, would probably amend his visions and suggest on ways the various umbrellas could be linked to computer systems enabling the continuation of credit – also when it rains and pours.

            Have a nice weekend.