[Islam-Online- Economy]

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 heterogenous investments and provides insight into how firms make investment decisions.