Fractional reserve is how fiduciary media (Fiat currency a.k.a. "the dollar") is created. It is the practice of lending out more than is on deposit. At first paper money comes into existence by banks trading transferable deposit slips for hard money on deposit. As soon as people accept these deposit slips in place of the hard money, the banks can issue as much currency as they can tolerate the risk of a bank run. Central banking and "deposit insurance" eliminates the risk of domestic bank runs, but it doesn't eliminate the risk of international demands for redemption of hard money.

The US headed off this international run on its central bank by being the global hegemon with an enormous navy and a nuclear arsenal. It has gone 51 years this way where the dollar is no longer redeemable for bullion both domestically and internationally. The dollar truly is the world currency and has been for decades. As a country, the US can literally import anything it wants on a loan that doesn't ever need to be paid because the dollars themselves are accepted as payment. So long as the world continues to demand dollars, the US inflation rate will remain suppressed and even potentially deflationary.

With bitcoin as the only domestically and globally accepted currency, there is no opportunity to loan out more bitcoin than there is on deposit. That's not to say that a bank can't misrepresent what its doing with your deposit, but so long as what a bank is lending out is bitcoin itself, it can only lend what it actually once had in its possession.

There already exists a business model that is active today similar to this old full-reserve lending absent a fractional reserve bank. For example; A person in the business of fixing up homes has a surplus of labor and material built up from managing property. He wants to buy a distressed property such as from an estate. If he has a $300k private loan, he can buy a property, send in his crew to clean and fix it up for sale and potentially turn a 40% profit. He is willing to share this profit for liquidity, and only take 30% profit by flipping the property within 6 months with the home leveraged on a secured 20% APR low origination fee loan. For the lender (or investor) he perceives this as low risk because he holds the title during this time as collateral and the property manager looks like a hired-gun on paper. The risk the investor has is if the property has unexpected problems, and the manager can't turn a profit on it, now the investor is holding the house and he has to flip it himself possibly at a loss. A bank is not willing to take this risk because its a short term loan, they don't want to be the owner of the property, and they charge much lower interest rates for long term loans to homeowners at a much lower risk. Here is a case where you can earn a high interest rate by being a full-reserve lender, but at high risk.

If fractional reserve lending were impossible under a bitcoin standard, then these low-risk long-term home loans would be open to a free market of full-reserve lending, and absent inflation or deflation, there would be lenders willing to loan their reserves out at a lower rate. There would still be a role for lending institutions, but they would look more like bond funds than checking accounts.

No. M0 subtracted from M1 is an artifact of fiat. Its the M1 demand deposits of fiduciary media that allows M3 to grow beyond hard assets.