Basel II and Dave’s Brilliant ‘Financial Striptease’
October 03, 07Few diamantaires have thoroughly analyzed the potential impact of the Basel II bank capital adequacy requirements on their businesses. It’s no wonder. Since the advanced economic and mathematical models that need to be developed by the banks are so complex and costly, the U.S. government has decided to have Basel II initially apply only to the 10 largest U.S. banks. In Europe and the rest of the world, banks aren’t that lucky.
Actually, the revolution that we will all be facing in the rules governing our relationships with the banks can appropriately be compared to the changes brought by the De Beers Supplier of Choice (SoC) model. Before SoC, DTC officials would get to know you, they’d come to bar mitzvahs and weddings, they’d know your business, and if you looked like a decent bloke and enjoyed strong broker support, you’d get a sight. It was strictly based on relationships; it was personal – and the memberships to the exclusive club were virtually guaranteed, provided you adhered to the norms.
With the introduction of SoC the decision-making was abruptly moved to computer models, using scorecards and other quantitative tools which would translate and reduce all the Sightholders’ attributes to complex formulas. De Beers’ executives would “wait” for the computer outcomes to know to whom they would supply rough.
This is exactly what Basel II is all about – a similar exercise to see to whom the banks will supply credit. Until now, it has been called “relationship banking.” Our bankers know our business, they visit our factories, and they are the guests of honor at family affairs. Basel II will completely, dramatically and abruptly change that. Both the diamond sector risks and the individual client risks will be rated by objective rating systems, subject to the monitoring, auditing, and by implication, also subject to the approval of the relevant supervisory authorities (mostly central banks).
Most diamantaires are not fully aware of the parameters (the raw data) employed in the banks’ internal rating system. There are differences in nuances among the various institutions. One thing, however, is abundantly clear. The financial statements of the borrower will become absolutely central. In some instances, they may be the only thing that counts.
In the good old days you might have a $2 million equity on your balance sheet, but a trusted banker would be aware of some kind of “inheritance” of $15 million being kept elsewhere that could justifiably be viewed as a part of the overall business. The credit allocation would be granted accordingly. Under Basel II that approach would be an absolute impossibility and the $15 million would only be taken into account if it were fully pledged as security for the borrower’s account.
A balance sheet with a little equity, with minimal profit margins, and only a few tangible assets will find it far harder to get access to serious borrowing in a Basel II environment. In the business where the ratios between equity and debt are something like 20-80 percent in the best of circumstances, Basel II will become a nightmare for some diamond companies, a “pain in the neck” to most, but also a distinct advantage to a growing number of companies.
Raising Public Money in Brussels
In this context, I would like to pay tribute to one Belgium diamantaire who has seen the writing on the wall and is doing something very courageous – unwittingly setting a precedent the entire Belgium diamond community may have to live with. Dave Lapa has gone through a “financial striptease” exercise, issuing a prospectus of 248 pages disclosing even the most minute and minor details of his business. On the basis of that prospectus, Lapa is raising on the Brussels Euronext Free Market, some $20 million through bonds, which are secured solely by the good name and reputation of Dave Lapa and his Overseas Diamonds company.
The bonds will have a coupon of eight percent and will run for eight years to mature in 2015. Lapa will use the proceeds of the bond issue to buy diamonds for inventory. Lapa realizes that he can’t depend on banks for this purpose. Diamond banks always claim that they don’t want to finance inventories, but they nevertheless do. (In the 2000-2005 period, in which De Beers dumped its $6 billion buffer stocks onto the markets, the banking debt went up accordingly. This happened even though banks were only financing the business (the conversion process of rough to polished) and not inventory itself.)
These kind of “accepted myths” will quickly become part of the diamond banking history and folklore. Lapa understands this and has taken the pro-active steps needed to defend and protect his future business and cover his financing requirements. But there’s more. By doing this in Belgium and not in Luxembourg or elsewhere, he has engendered transparency at unprecedented levels where it counts most – at home.
The irony is, by virtue of the very exercise he has done, Lapa has positioned himself exceptionally well to secure a positive rating under the Basel II client-risk assessment process. Money begets money; under Basel II, balance sheet transparency begets money.
Overseas Diamonds isn’t one of a dozen large international “supertankers” in the Belgium diamond industry. It’s probably more correct to call it a medium-sized company serving niche markets, concentrating on high-quality niche products. As a business model, it has a future. After the “financial striptease,” anyone can recognize this.
There are other companies that are getting ready for tomorrow by moving offshore, by conducting financial engineering and creative accounting. That’s legitimate. Dave Lapa has utilized last year’s tax amnesty (i.e. the revaluation of stocks) to increase his equity by some 35 percent. He does not offer any security or preferential rights to bondholders. The interest rate is fixed and only God knows at what price the bonds will be traded.
One can subscribe to the Euro-nominated bonds up to October 26, 2007. Will it be successful? We don’t know. We don’t know whether the bond issue will proceed. Dave Lapa himself says that he personally will not be buying and the purchasers of these bonds will genuinely come from the public. In Belgium there are probably many investors interested in getting a share of diamond earnings, and this is indirectly an intriguing way to do so.
Now back to Basel II. Even if the bond issue would fail – the “financial striptease” will reap benefits within the banking system. When all the data is absorbed in the new models, banks will have the comfort of knowing everything they would ever want to know about Dave Lapa and Overseas Diamonds. Clients and suppliers who are (or will be) required to do a company due diligence for anti-money laundering compliance purposes, have more than they could ever ask for.
I am not sure whether Dave felt exhausted and “naked” when he made his prospectus public last week. This type of honorable “striptease” should give him a warm feeling and earn him respect. I am wondering – who will be next?
Have a nice weekend.