The problem economically with fractional reserve banking is similar to the problem of fiat money. Neither the production of fiduciary media, i.e. fractionally backed money substitutes, nor the production of fiat money can be regulated by profit. Without profit and loss as a guide, production will be inefficient. A bank can issue fiduciary media out of thin air by making a loan to a customer and writing the funds into his checking account. The bank is not intermediating credit from a saver by doing this but creating it with the issue of fiduciary media. It is always profitable to issue more fiduciary media. The interest a bank earns on the loan is always greater than the nominal cost of writing funds into a checking account.
In like fashion, a central bank prints fiat paper money. It is always profitable to print more. Without special privileges in law, like legal tender laws, fiat money would not arise on the market. Fiat money would not develop a wide clientele as a medium of exchange in free competition with commodity money.
In like fashion, fiduciary media is supported by legal privilege. Money certificates came into existence as warehouse receipts for money. The “bank” did not own the gold money placed by the customer in its vault for safe keeping. In order to legally loan the funds warehoused by a customer, the state had to supplant bailment contracts with “deposit” contracts. But, legislation cannot bring about conditions contrary to economic reality. It merely creates inconsistencies in private property claims. Fractional reserves mean that more than one party holds mutually exclusive claims to the same money.
In a “deposit” contract, the customer transfers ownership of money to the bank who then issues a claim to pay the customer money in the future. Such contracts are suitable for intermediating credit. Without special privileges in law, deposits would not develop a wide clientele as a medium of exchange in free competition with money certificates.
Take a look at Murray Rothbard’s What Has Government Done to Our Money?