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).