A Markov Chain Model for Islamic Micro-Financing

Abstract

This paper introduces a Markov chain model for Islamic micro-financing, especially mudarabah and murababah contract. Mudarabah and murabahah are two Islamic micro-financing contracts that have enormous potential in creating a balance between the monetary and sharia sector because these two products are moving to manage the business sector which undoubtedly adds value to the economic movement directly. On the other hand, these two contracts have the potential to cause problems in their implementation. The most common problem of the two contracts is asymmetric information, which consists of adverse selection and moral hazard. We propose the Markov chain model as a solution for the Islamic banks to reduce the risk because of adverse selection and moral hazard in mudarabah and murabahah contract. In our model, we also propose a mechanism to avoid strategic default in mudarabah contract. We observed two different probabilities of an applicant to become a beneficiary to find the solution to the problems. The results of this study, the bank can decrease the probability of an applicant to become a beneficiary to reduce the adverse selection and moral hazard in mudarabah and murabahah contract.

A Bayesian Game for a Profit and Loss Sharing Contract

“…Relying on Monte Carlo simulation, they indicate that a high profit-sharing ratio is needed to avoid asymmetric information, meaning that such a ratio can avoid adverse selection. Lessy et al (2019) present a Markov chain model as a solution to adverse selection in PLS (mudarabah) contracts. According to them, the probability value of an applicant receiving investment from an Islamic bank will influence the possibility of adverse selection.…”

“…A PLS contract involves high risk due to adverse selection and moral hazard problems. According to Lessy, Koudjeti, Diener, and Diener (2019), the risk associated with such a contract can occur at the time of the contract being agreed or during the contract period. In the related literature, several studies have considered the problems related to PLS contracts.…”

“…Sapuan (2016) states that this type of contract is becoming less preferable because of information asymmetry and consequently the presence of adverse section and moral hazard problems. Apart from these studies, several other works discuss PLS contracts, including those of Fakir and Tkiouat (2016), Jouaber and Mehri (2017), Ajmi, Aziz, Kassim, and Mansour (2019), and Lessy et al (2019). We will describe these studies in more detail in section 2.2.…”