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

Start your day with The Independent, sign up for daily news emails
Voices
There will be a chance to bid for a rare example of the SAS Diary, collated by a former member of the regiment in the aftermath of World War II but only published – in a limited run of just 5,000 – in 2011
charity appealTime is running out to secure your favourite lot as our auction closes at 2pm today
News
File: James Woods attends the 52nd New York Film Festival at Walter Reade Theater on September 27, 2014
peopleActor was tweeting in wake of NYPD police shooting
Sport
Martin Skrtel heads in the dramatic equaliser
SPORTLiverpool vs Arsenal match report: Bandaged Martin Skrtel heads home in the 97th-minute
News
Billie Whitelaw was best known for her close collaboration with playwright Samuel Beckett, here performing in a Beckett Trilogy at The Riverside Studios, Hammersmith
people'Omen' star was best known for stage work with Samuel Beckett
PROMOTED VIDEO
ebooks
ebooksA year of political gossip, levity and intrigue from the sharpest pen in Westminster
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Carlton Senior Appointments: Private Banking Manager - Intl Bank - Los Angeles

$200 - $350 per annum: Carlton Senior Appointments: Managing Producer – Office...

Carlton Senior Appointments: San Fran - Investment Advisor – Ind Advisory Firm

$125 - $225 per annum: Carlton Senior Appointments: San Fran - Investment Advi...

Sheridan Maine: Commercial Finance Manager

Up to £70,000 per annum + benefits: Sheridan Maine: Are you a qualified accoun...

Sheridan Maine: Regulatory Reporting Accountant

Up to £65,000 per annum + benefits: Sheridan Maine: Are you a qualified accoun...

Day In a Page

Surrounded by high-rise flats is a little house filled with Lebanon’s history - clocks, rifles, frogmen’s uniforms and colonial helmets

Clocks, rifles, swords, frogmen’s uniforms

Surrounded by high-rise flats is a little house filled with Lebanon’s history
Return to Gaza: Four months on, the wounds left by Israel's bombardment have not yet healed

Four months after the bombardment, Gaza’s wounds are yet to heal

Kim Sengupta is reunited with a man whose plight mirrors the suffering of the Palestinian people
Gastric surgery: Is it really the answer to the UK's obesity epidemic?

Is gastric surgery really the answer to the UK's obesity epidemic?

Critics argue that it’s crazy to operate on healthy people just to stop them eating
Homeless Veterans appeal: Christmas charity auction Part 2 - now LIVE

Homeless Veterans appeal: Christmas charity auction

Bid on original art, or trips of a lifetime to Africa or the 'Corrie' set, and help Homeless Veterans
Pantomime rings the changes to welcome autistic theatre-goers

Autism-friendly theatre

Pantomime leads the pack in quest to welcome all
The week Hollywood got scared and had to grow up a bit

The week Hollywood got scared and had to grow up a bit

Sony suffered a chorus of disapproval after it withdrew 'The Interview', but it's not too late for it to take a stand, says Joan Smith
From Widow Twankey to Mother Goose, how do the men who play panto dames get themselves ready for the performance of a lifetime?

Panto dames: before and after

From Widow Twankey to Mother Goose, how do the men who play panto dames get themselves ready for the performance of a lifetime?
Thirties murder mystery novel is surprise runaway Christmas hit

Thirties murder mystery novel is surprise runaway Christmas hit

Booksellers say readers are turning away from dark modern thrillers and back to the golden age of crime writing
Anne-Marie Huby: 'Charities deserve the best,' says founder of JustGiving

Anne-Marie Huby: 'Charities deserve the best'

Ten million of us have used the JustGiving website to donate to good causes. Its co-founder says that being dynamic is as important as being kind
The botanist who hunts for giant trees at Kew Gardens

The man who hunts giants

A Kew Gardens botanist has found 25 new large tree species - and he's sure there are more out there
The 12 ways of Christmas: Spare a thought for those who will be working to keep others safe during the festive season

The 12 ways of Christmas

We speak to a dozen people who will be working to keep others safe, happy and healthy over the holidays
Birdwatching men have a lot in common with their feathered friends, new study shows

The male exhibits strange behaviour

A new study shows that birdwatching men have a lot in common with their feathered friends...
Diaries of Evelyn Waugh, Virginia Woolf and Noël Coward reveal how they coped with the December blues

Famous diaries: Christmas week in history

Noël Coward parties into the night, Alan Clark bemoans the cost of servants, Evelyn Waugh ponders his drinking…
From noble to narky, the fall of the open letter

From noble to narky, the fall of the open letter

The great tradition of St Paul and Zola reached its nadir with a hungry worker's rant to Russell Brand, says DJ Taylor
A Christmas ghost story by Alison Moore: A prodigal daughter has a breakthrough

A Christmas ghost story by Alison Moore

The story was published earlier this month in 'Poor Souls' Light: Seven Curious Tales'