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Fundamentals of Business Economics and Management · Money and Banking

Functions of Commercial Banks and Credit Creation Explained

Updated 10 October 2026 · Fact-checked

Commercial banks accept deposits and lend money (primary functions) and also offer services like remittance, locker and agency work (secondary functions). They create credit because loans return as fresh deposits. Maximum deposit creation = initial deposit × 1 ÷ reserve ratio. Solve by finding the multiplier first.

Understand Functions of Commercial Banks and Credit Creation

A commercial bank is a financial institution that accepts deposits from the public and lends them to people and businesses to earn a profit. Examples are SBI, HDFC Bank and Canara Bank.

The functions are split in two groups. Primary functions are the core business: accepting deposits and granting loans. Deposits are of three main types. Current deposits can be withdrawn any time, usually pay no interest and suit traders. Savings deposits allow limited withdrawals and pay modest interest. Fixed (term) deposits are kept for a fixed period at a higher interest rate, and early withdrawal normally attracts a penalty. Recurring deposits are a related type where you deposit a fixed amount every month. Loans include cash credit, overdraft, term loans and discounting of bills.

Secondary functions support the core business. They have two sub-groups. Agency functions include collecting cheques, paying bills and insurance premiums on your behalf, and buying or selling securities. General utility functions include safe deposit lockers, issuing drafts and letters of credit, foreign exchange dealing, and acting as a guarantor.

Credit creation means banks can lend more than the cash they receive. Banks know that depositors do not all withdraw together, so they keep only a fraction as a reserve and lend the rest. The borrower spends the loan, the seller deposits it in a bank, and that bank lends again. Each round creates new deposits.

Suppose the reserve ratio is 10%. A deposit of ₹1,000 lets the bank lend ₹900. That ₹900 comes back as a deposit, and ₹810 is lent next. The chain continues with shrinking amounts. The total is capped by the money multiplier, which is 1 ÷ reserve ratio. The simple model assumes all loans return to the banking system and no cash is held outside banks.

Key formulas to remember

Money (credit) multiplier
Multiplier = 1 ÷ r, where r = reserve ratio (as a fraction)
Simple model: no cash leakage, all loans redeposited. A 20% ratio gives 1 ÷ 0.20 = 5.
Total deposits created
Total deposits = Initial deposit × (1 ÷ r)
This includes the initial deposit itself.
Credit created (new loans)
Loans created = Total deposits − Initial deposit
Use when the question asks for additional credit, not total deposits.
Loanable amount in one round
Lendable = Deposit × (1 − r)
Bank keeps r as reserve and lends the rest.

How to solve Functions of Commercial Banks and Credit Creation questions

Use this order for theory and numerical questions on this topic.

  1. 1Read what is asked: a function, a deposit type, total deposits or additional credit.
  2. 2For function questions, decide if it is primary (deposits, loans) or secondary (agency, general utility).
  3. 3For deposit questions, match the clue: no interest and any-time withdrawal means current; limited withdrawals means savings; fixed period and higher interest means fixed.
  4. 4For numericals, convert the reserve ratio to a fraction (20% = 0.20).
  5. 5Compute the multiplier as 1 ÷ r.
  6. 6Multiply by the initial deposit to get total deposits.
  7. 7If the question asks for credit or loans created, subtract the initial deposit.
  8. 8Check the answer against the four options and make sure the units are in rupees.

Quickest way: Multiplier shortcut

When to use it: Any numerical question giving an initial deposit and a reserve ratio.

  1. Turn the percentage into 100 ÷ percentage. A 25% ratio gives 4, a 20% ratio gives 5, a 10% ratio gives 10.
  2. Multiply by the deposit for total deposits.
  3. Subtract the deposit only if the word 'additional' or 'loans' appears.
  4. For function questions, spot the keyword: lockers, drafts, collection mean secondary; accepting deposits and lending mean primary.

Common mistakes in Functions of Commercial Banks and Credit Creation

  • Using the multiplier as r ÷ 1 or multiplying the deposit by r.

    Students mix up the formula with the reserve amount.

    Fix: Remember the multiplier is always larger than 1. It is 1 ÷ r, so a smaller reserve ratio gives a bigger multiplier.

  • Giving total deposits when the question asks for credit created.

    The word 'additional' or 'loans' is missed under time pressure.

    Fix: Underline the ask. Credit created = total deposits − initial deposit.

  • Calling lockers and drafts primary functions.

    These are common daily services, so they feel central.

    Fix: Primary means only accepting deposits and lending. Everything else is secondary.

  • Saying current deposits pay high interest.

    Students confuse them with fixed deposits.

    Fix: Current accounts pay little or no interest. Fixed deposits pay the highest.

  • Believing a single bank can create unlimited money.

    The chain of loans looks endless.

    Fix: Creation is limited by the reserve ratio. The multiplier sets the maximum.

Worked examples

Example 1

A person deposits ₹50,000 in a bank. The reserve ratio is 20%. What is the maximum total deposit that can be created in the banking system?

Show the solution
  1. Reserve ratio r = 20% = 0.20.
  2. Multiplier = 1 ÷ 0.20 = 5.
  3. Total deposits = 50,000 × 5 = ₹2,50,000.

Answer: ₹2,50,000

Example 2

With an initial deposit of ₹1,00,000 and a reserve ratio of 10%, how much additional credit can banks create?

Show the solution
  1. Multiplier = 1 ÷ 0.10 = 10.
  2. Total deposits = 1,00,000 × 10 = ₹10,00,000.
  3. Additional credit = 10,00,000 − 1,00,000 = ₹9,00,000.

Answer: ₹9,00,000

Exam tips

  • Numericals are nearly always simple: 10%, 20% or 25% ratios. Do them mentally with the 100 ÷ percentage trick.
  • Read whether the question wants total deposits or additional credit before calculating.
  • For classification questions, sort each service into primary, agency or general utility.
  • No negative marking applies, so attempt every question and eliminate options that break the multiplier logic, such as an answer smaller than the initial deposit.

Practice questions from Money and Banking

Functions of Commercial Banks and Credit Creation in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Functions of Commercial Banks and Credit Creation: frequently asked questions

What are the primary functions of commercial banks?

The primary functions are accepting deposits and granting loans and advances. Deposits include current, savings and fixed accounts. Loans include overdraft, cash credit and term loans.

How do banks create money?

Banks keep a fraction of deposits as reserve and lend the rest. The loan is spent and redeposited in the banking system, which allows further lending. Repeating this builds total deposits several times the first deposit.

What is the formula for the money multiplier?

In the simple model, the multiplier is 1 ÷ reserve ratio. With a 20% ratio, it is 5. It assumes no cash leakage outside banks.

What is the difference between current, savings and fixed deposits?

Current deposits allow unlimited withdrawals and usually earn no interest. Savings deposits allow limited withdrawals with modest interest. Fixed deposits lock money for a period and pay higher interest.