Commercial banks engage in credit creation by accepting primary deposits from customers and using some of those deposits to issue loans and advances, thereby creating derivative deposits. This process of using deposits to issue loans that themselves generate further deposits allows banks to multiply the money supply through the fractional reserve system. As shown through examples of Banks A, B, and C, each new loan issued creates a new deposit, with the amount of deposits and loans growing until reserves become too small to support additional lending.

1. Credit creation is one of the most important function
of commercial bank. The process of credit creation occurs
when bank accepts deposits and provide loans and
advances from these deposits. Modern banks plays the
dual role while performing this function. Its deposits may
originate in two forms

2. When customer deposits money with the bank, they are called
as PRIMARY DEPOSITS. Under the RBI Act of 1935, every commercial
bank has to keep certain amount of deposit as reserve with RBI.
Deposited amount is not withdrawn immediately by depositor so
bank provide that amount as loans & advances .
THUS, EVERY DEPOSITS CREATES A LOAN
Derivative deposits refer to the deposits created by the banking
system while performing other fundamental functions of loans.
When any bank sanctions a loan to its customer it does not make a
cash payment to the party concerned but opens a new account i.e.
DERIVATIVE DEPOSITS, in the name of borrower. Now this deposit is
the result of lending activity of bank.
THUS, EVERY LOAN CREATES A DEPOSITS.

4. LIABLITIES AMOUNT ASSETS AMOUNT
Deposits 10000 Cash 1000
Loans 9000
10000 10000
BANK ‘A’
LIABLITIES AMOUNT ASSETS AMOUNT
Deposits 9000 Cash 900
Loans 8100
9000 9000
BANK ‘B’
LIABLITIES AMOUNT ASSETS AMOUNT
Deposits 8100 Cash 810
Loans 7290
8100 8100
BANK ‘C’
The process of credit creation continues until last deposit becomes too
small to create any more loans.