How do Banks makes Money?
Credit creation is the important function of commercial banks. Commercial bank expands their deposit by giving loans and advances. This can be further explained with the Numerical example.
Suppose a person deposits 1,00,000 Rs cash with the bank, this is called Primary deposit with the bank. The knows from their historical experience that all the depositors do not demand all their money at the same time, but some portion of it maybe demanded at any time. Hence keeping it reserve at part of their deposit. The remained can be given as a loan. This reserve is known as Legal Reserve. In India RBI fixed the legal reserve ratio (CRR/SLR).
Suppose in above example LRR is 20%. So, 20% of cash deposit i.e., 20,000 Rs will be kept as Cash Reserve and 80,000 Rs will be given as loan. The bank does not give cash deposit cash advances to their customer, instead they issue only cheque, So the person who get the cheque of Rs 80,000 will deposit into his bank account. In this process a new deposit of 80,000 Rs has been created by the bank. After keeping 20% of this i.e 16,000 Rs the remained 64,000 Rs will be given as a loan. In this process a new deposit of 64,000 has been created by the bank. After keeping 20% of this, the remainder can be given as a loan. This process goes and goes on. This process comes to an end when total cash reserve is equal to initial primary deposit and other process banks are able to create total deposit up to 5,00,000 Rs. 1/LRR*Primary deposit= Total credit creation. 1/ 20/100* 100000= 5,00,000.