A MARKOV CHAIN MODEL FOR ISLAMIC MICRO-FINANCING

Abstract

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