The Benchmark Issue in the Islamic Financial System

Abstract

This paper identifies a major lacuna in the conceptual development of
Islamic financial market operations. It argues that in the absence of a
well developed benchmark that would facilitate macro- and micro-level
decision making with regards to cost of capital and opportunity cost of
investments in comparative projects of similar risk, Islamic financial
institutions are relying on interest rate-based indices such as the London
Inter-Bank Offer Rate (LIBOR) to make lending decisions. The author
contends that this is clearly unacceptable since Islam disallows a predetermined
or fixed rate of capital. The paper then proposes a benchmark
based on Tobin’s q theory of investment. The author further maintains
that unlike existing alternatives which are limited to macro-level
applications only, the q-based benchmark would be useful for firms and
banks (micro-decisions) as well as governments and institutions
(macro-planning).