When you operate a fractional reserve, other people/businesses owe you at least as much money as you owe to your deposit accountholders.
When you're insolvent, you can't cover your obligations. Even if you called in every loan you'd made, it still wouldn't give you enough cash that all your deposit account customers could withdraw all their money.
Calling Mt. Gox a "fractional reserve" is giving them way too much credit.
Being insolvent means that they can't cover your obligations right now. If you deposit 100BTC in my wallet, I invest it for a year and you want it back right now I'm insolvent because I can't pay you right now; despite my books being perfectly balanced.
In the event of everyone wanting to withdraw their money at once, operating a fractional reserve and being insolvent are basically the same (unless you can instantly get the money out of your investments). That's a major reason why fractional reserve banking is frowned upon in the bitcoin ecosystem.
Fractional reserve banking can be done with bitcoin just as with any underlying "base asset" such as gold or Federal Reserve Banknotes. It just means that the banks can lend most of the asset, and must keep back a fraction for liquidity purposes (in case a depositor wants some of their asset back).
In many ways Fractional Reserve Banking would be much more risky with bitcoin than with banknotes; with banknotes at least there is a lender-of-last-resort central bank. The central bank can create additional money at will to lend to a bank that is in a liquidity crisis, to see it through the crisis. With bitcoin, there is no such operator.
Now if nobody ever lends or borrows bitcoin, then there will be no issue - but lending and borrowing has been quite central to commerce over the last couple of centuries, with mostly decent effects. Personally I'm not sure bitcoin economics are that well thought out!
Sure fractional reserve banking can be done with bitcoin. It's not a problem of the currency but of the environment and ecosystem.
A regular bank is well-trusted and insured. A bank run is unlikely because of the trust and even in that case the insurance or a lender can keep the bank solvent. A bitcoin bank is at best moderately trusted and is almost always uninsured. Minor events can lead to panic which leads to a bank run, which leads to insolvency because there is neither insurance nor a good lending infrastructure available to most bitcoin banks.
Concerning lending: there is a small but growing bitcoin lending community, but it's closer to Kickstarter or the VC model. Credits are not given out by banks but by a number of small investors. It's not very efficient yet, but it kind of works.
Well as I see it there are only really two possibilities: full reserve or fractional reserve, and I've never really seen full reserve banking (i.e. demand deposits cannot be lent).
Lending term deposits cannot provide a guarantee of full reserve, because term deposits mature and you cannot absolutely guarantee that you will have reserves on hand to meet them when they mature.
You can have "full reserve" of demand (including matured term) deposits as a goal and lend out term deposits, but you get at best a statistical probability approaching -- but never equaling -- unity of maintaining full reserve based on past repayment and new deposit patterns.
To be honest, I don't see how you could possibly do fractional reserve with Bitcoin. By definition fractional reserve is lending more currency than you have. Banks can do this because they are allowed to create the money that they lend. So if I am allowed a 10:1 ratio of lending and reserve, as long as I maintain $1 in my reserve, I'm allowed to lend $10. Those $10 are poofed into existence when the loan is created, though.
As another person mentioned, I think you are confusing lending with reserve banking. A bank (or any entity) is allowed to lend as much money as they want to someone if they are actually lending money that they have. That's not fractional reserve. Fractional reserve creates money. The fraction limits how much money you are allowed to create.
You can't do that with Bitcoin by design. Of course, you can lend money (that you have) with Bitcoin. There is currently no automated way to record that the transaction was a loan as opposed to a payment, but that's true of all currencies. In fact Bitcoin had some plans to implement contracts in the protocol, but I don't think anyone has done it yet.
If I am to opine slightly, I think that Bitcoin's lack of ability to do fractional reserve is probably a mistake. I think it relegates it to a payment method as opposed to a viable currency. The problem with Bitcoin as a currency is the lack of availability. Although it often doesn't look like it, I think the purpose of a currency is to get resources into the hands of people who need resources, but don't have it. With Bitcoin, the currency is a limited resource and those that have it have no particular reason to spread it around. With a more traditional currency, the money supply can grow to match demand. The banks which create the currency have an incentive to loan money because the money that they are loaning is springing into existence at that time -- they aren't loaning their own money. The only thing the banks need to worry about is that on average, the growth produced by the loan is greater than the interest charged. Having a fluid money supply like this allows people who do not have money to get it and reduces inefficiencies (i.e. people being idle because they don't have the resources to produce something).
Having said all that, I have no idea how you could implement fractional reserve in a distributed system and have any protection for horrible abuses. Until that problem is solved, I can't really see a way for this kind of currency to act as a true currency (as opposed to a payment method). If I remember correctly, there was a review of Bitcoin by a prominent economist a few years ago that pointed out this problem.
> A bank (or any entity) is allowed to lend as much money as they want to someone if they are actually lending money that they have.
No they are not. There are supervisory limits on what a bank can lend (leverage ratios, capital adequacy rations etc.).
> By definition fractional reserve is lending more currency than you have.
No it is not, it is lending a fraction (less than 100%) of the money that has been deposited with you.
I think the confusion comes from that in todays banking system there are two sorts of money that seem very similar - the base money (federal bank notes) and the bank money (loans/deposits of federal bank notes). The loans/deposits can also be used as money but crucially they are NOT the underlying money even if it is very easy to convert one to the other (depositing or withdrawing the base money). Example: I can buy something with the fact that Chase bank owes me bank notes (with the loan I made to it), by changing the ownership of that loan to the shop I want to buy something from. I have a bank card that makes that transfer very simple.
The 10:1 ratio is a limit on bank money (loans / deposits) to base money (federal bank notes). Both sorts of money are denominated in dollars, but they are different and have different supply and demand.
To recap, by keeping careful records of the loans / deposits, and making systems to easily transfer ownership of the loans and deposits, these loans end up also having characteristics of money - they can be used for transactions, for accounting etc.
> You can't do that with Bitcoin by design
You absolutely can. The loans/deposits form of bank money could work with bitcoin as the base money, and you could have the same rules around fractional reserve, capital adequacy rules, liquidity ratio rules etc. that the normal banking system has.
Here's how to create a fractional reserve with bitcoin.
1) create a service that offers to store people's bitcoins safely.
2) give depositors an option to receive interest in their bitcoins if they'll allow you to loan them other people.
3) loan some (but not all) of those bitcoins to other people, and charge interest.
4) collect the interest, (optionally pay part of it to the depositors), and use it to fund your operation.
That's it.
I get that you don't think that's fractional reserve banking, but you're wrong. I have just accurately described how the money 'poofs' into existence. I get that you don't understand this truth, but it is indeed a truth.
The main difference between a fractional-reserve BitCoin bank and a conventional bank would be that there would be no lender of last resort to use in case of a bank run.
Other than that, you'd still fulfill the basic function of creating liquidity -- any individual depositor has full access to their money, and your creditors also make use of it, so the money supply increases.
Just because there's no BitCoin-denominated lender of last resort also doesn't necessarily screw you in case of a bank run. If your loans are sound, any individual bank could probably find lenders in case of a run: if all of a banks depositors want their BitCoin back at once, the bank would go to other banks or lenders and borrow BitCoin against the value of their loans. As long as there is sufficient liquidity in the entire banking system, the individual banks could survive a run.
You could also get around the lack of a BitCoin-denominated lender of last resort by using a non-BitCoin-denominated lender of last resort: while the accounts may be BitCoin-denominated, you could (in the ToS) give the depositors an equivalent amount of USD if you "run out" of BitCoin and you are unable to borrow BitCoin from other lenders. It'd be more complex because you'd need to borrow USD against the value of the BTC-denominated loans you yourself have, and then insure against the risk of a BTC crash, but that's the sort of think that financial and insurance people do all the time.
> Being insolvent means that they can't cover your obligations right now
No, it doesn't. If it did it would mean that everyone with a mortgage is insolvent, as would most businesses (what sort of business keeps a 1:1 debt/cash ratio?). What insolvent means is that you don't have enough cash, and/or assets with enough liquidity to be able to pay your debts.
Banks are fine, because for the most part they can sell debtors for cents on the dollar when they really need the cash.
When you're insolvent, you can't cover your obligations. Even if you called in every loan you'd made, it still wouldn't give you enough cash that all your deposit account customers could withdraw all their money.
Calling Mt. Gox a "fractional reserve" is giving them way too much credit.