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Current
Practice
Currently,
Islamic financial markets are dominated by short-term trade
financing instruments. According to some estimates, 80 percent of
investment is being channeled through the "cost-plus" (murabaha)
mode of financing. The common practice in the market is to use the
LIBOR as the reference rate for mark-up. Similarly, the LIBOR is
used for pricing and measuring the performance of Islamic leasing
funds. In the absence of LIBOR, the prevailing market interest rate
would serve the same purpose.
Historically, several factors have
contributed to the establishment of this practice. First, Islamic
financial institutions required a common reference rate to integrate
with international capital markets. Second, as Western banks entered
into the Islamic financial markets, they required a comparable
benchmark against their cost of funding in the conventional system,
which happened to be the LIBOR. These institutions treated the
murabaha mode as synonymous with the conventional money market,
which was based on the LIBOR.1
Finally,
in those markets where Islamic financial institutions coexisted with
conventional banks, the LIBOR became a benchmark for competition in
attracting depositors.2
The
prevalent practice is defended by the arguments that, in the case of
the murabaha mode of financing, a practice to charge the LIBOR-based
"mark-up" is still Islamic because it is part of the sale
agreement price between two parties; and, in case of leasing funds,
the LIBOR is used for pricing and performance measurement purposes
only and does not influence the actual rate of return on the
investment.3 Further, the LIBOR
provides price transparency and global real-time accessibility,
which facilitates ease of operation and integration of Islamic and
international financial markets.4
Irrespective of various justifications provided for the practice,
obviously the use of any interest rate as part of a mark-up (pricing
or performance) is not acceptable because interest rate does not
represent real rate of return in the economy as intended by Islamic
principles. Although ease of use is the reason cited, the real
reason is the lack of a more suitable measure. Finding a practical
solution for a benchmark compatible with Islamic principles requires
an understanding of the concept of cost of capital in the context of
an Islamic financial system. The cost of capital provides a common
reference point for comparing heterogeneous investments and provides
insight into how firms make investment decisions.
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