The primary function of commercial banks is money creation or credit creation in an economy. By the historical experience of commercial banks, they know that the depositors would not be withdrawing all of their funds at a particular time.
That is why, they create credit in the form of much higher demand deposits than their cash reserves. Commercial banks issue loans on the basis of their demand deposits, even if a fraction of the amount is with them as cash reserves.
In this way, they contribute to increase the flow of money in an economy by the process of credit creation, e.g. suppose a bank has a cash reserve of ? 1500 and demand deposits of Rs 12000. It means . the bank is creating credit of 8 times of 1/5 cash reserve.
If the withdrawls are 12.5% of the deposits, the bank needs to keep only 12.5% of its total deposits as cash (CRR).
Now, the bank can issue loans to its customers on the basis of these demand deposits, as loans are never offered in cash, but only as demand deposits in favour of the customers. Suppose, the bank issues loan of ? 10500 to its customers keeping Rs 1500 as cash reserve. Now, this loan is also with the bank as demand deposit. Again, the bank keeps 12.5% of this Rs 10500 and can give ? 9187.5 to its customers as loan.
Thus, the money goes on multiplying and creates new flow of money in the economy.
The total credit creation by this bank can be obtained by the following formula: