We can learn some lessons from George Bailey's morality tale

Much as the British are treated to The Sound of Music on television every Christmas, we Americans get It's a Wonderful Life. It stars the American icon and all-round good guy Jimmy Stewart playing George Bailey, a dedicated, honest banker. George's bank faces a run based on a rumour – spread by the movie's bad guy – that his bank is insolvent.

Although George is trustworthy, when his customers stream into his bank to demand their deposits, he is forced to admit that the rumour is true, and that the "demand deposits" he sold them were fundamentally fraudulent securities. In fact, he can't deliver on his promise to return all deposits immediately and fully on demand because he has taken his customers' money and lent it to other people in town.

No matter, the depositors want their money back. George becomes despondent, attempts to take his life, is rescued by an angel and, at the last minute, the townsfolk club together to give their money back.

It's a Wonderful Life is a morality play, but also gives a quick lesson in economic fragility – it shows that the economy, be it local, national or international, can flip from a very good position to a very bad one based on the sort of collective, self-fulfilling beliefs that John Maynard Keynes called "animal spirits".

Today, on Main Streets in America and much of the world, a different movie – It's a Horrible Mess – is playing. It features widespread unemployment and foreclosures, and an economically terrified populace.

It is about bankers who collectively manufactured some $2trn in fraudulent mortgages and other loans, which we now call "toxic assets". The fraud here was not making the loans to people with high probability of being unable to repay. Nor was it bundling such loans into pools.

The fraud arose in initiating the loan, in specifying that the borrower's income was X, when it was Y, or that the house she was buying – the collateral she was offering – was worth far more than was the case.

The fraud was sustained by rating companies which were paid astronomical fees to ignore the facts, by insurance companies eager to insure the uninsurable, by regulators which were looking out for their next job, not for the public interest, by "top" management that sought to take the money and run, and by politicians who wanted to get people into houses so they could brag about this accomplishment and get re-elected.

Let us bear in mind that the vast majority of people on Wall Street and Lombard Street were good guys, like George, who ended up selling products that they thought were safe.

When someone screams "Fire" in a dark cinema, panic and death can ensure. There are two responses. One is to tell people not to scream and walk slowly to the exit. The other is to turn on the lights.

In our current economic context, turning on the lights means having the government oversee the initiation of the securities – verifying, via tax records, the income statements, hiring independent appraisers and rating companies to assess collateral values and the risk of the asset in question, and supervising the custody of the assets once purchased. It also means putting all this information immediately on the web.

Had George posted on his bank walls details of all the loans he'd made and had the government verified this information, his chances of facing a run would have been much lower.

But disclosure alone would not suffice. What is also needed is to tie the individual to the group. Imagine what would happen in the cinema if everyone knew that unless everyone got out, no one would get out. People would walk, not run, to the doors and help the old and infirm out first.

Focusing George's lenders on their mutual interest is another very simple thing to do. Rather than have George take their money and hand them back a cheque book, let's have him hand them back shares in the bank. His lenders are now shareholders of the bank, not creditors of the banks. Now they are interested in collectively maximising the bank's profits, not running out the door at the first sign of trouble.

But doing this raises another problem. Some of George's lenders want to lend to businesses and not to homebuyers and others want to do the opposite. The solution is simple: transform the bank into a mutual fund (unit trust) company, in which each mutual fund the bank markets shares, invested in specific types of securities, which are fully verified, disclosed, and independently rated by the government.

Doing this in effect breaks George's bank up into lots of small banks, each of which has a 100 per cent capital requirement. George's lenders and other investors now know precisely what financial products they are buying.

They also know that if they are investing in a mutual fund that is buying illiquid assets, the fund will be established on a closed-end basis, which entails no forced liquidations of the assets. If a particular shareholder of a closed-end fund wants out, he can sell his shares of the fund in the market, but can't force George to recall a loan to the town's bakery.

These two elements – transforming all banks, insurance companies, and other financial corporations into mutual funds and having the government verify, disclose and independently rate and assess all securities held by mutual funds – constitutes the essence of my "limited purpose banking" proposal.

The proposal's title says we need to limit all financial corporations (for example, banks whose owners face no personal liability for their actions) to their sole legitimate purpose, namely financial intermediation – connecting lenders to borrowers and savers to investors. This is a form, but not necessarily the form, of utility banking, which Bank of England governor Mervyn King is so courageously promoting.

Limited purpose banking doesn't restrict credit. Lenders will buy mutual funds investing in mortgages and small and large business loans and those mutual funds will use their investors' money to make those mortgages and loans. Nor does it restrict leverage or modern finance. A collateralised debt obligation is, in essence, a mutual fund in which the different investors are leveraged vis-à-vis each other. What limited purpose banking does is restrict fraud, malfeasance, management and director looting and political kickbacks by making our financial system simple, honest and transparent.

President Barack Obama and Paul Volcker, his adviser and former chairman of the federal reserve, have a different plan. They want to babysit, tax and restrict the investment of large commercial banks. Big investment banks will be allowed to run their own shows. But Uncle Sam will have funeral plans in place to bury these rogue banks once they fail.

Compared with the Obama-Volcker plan to "re-enact Glass-Steagall" (the 1933 act of Congress intended to curb the excesses that led to the Wall Street crash), limited purpose banking sounds radical.

But what I propose is to turn all of the big banks and insurers into pass-through mutual fund companies, and transform their investment banking operations into consulting business (which neither borrow nor invest), and ensure their broker-dealers simply match buyers and sellers of securities with no net exposure. This will turn on the lights so people can see what financial products they are buying. Although it may sound radical, it's actually far safer and economically healthier than leaving the current system essentially as it is and making plans for the next colossal financial funeral.

If America goes the Obama/Volcker route, the next big run will surely be on Uncle Sam, which is making AIG look like a model of financial prudence and Greece look like a model of fiscal frugality. When that run happens, the global economy, which is still hanging by a thread, will get a real taste of animal spirits – 1930s-style animal spirits.

Laurence Kotlikoff is professor of economics at Boston University and author of Jimmy Stewart Is Dead: Ending the World's Ongoing Financial Plague with Limited Purpose Banking