Well... I think it can still be done and keep it within a Star Wars setting.
But right now... well, other than what I have outlined above, it has two fatal flaws:
1. Your actions set your morality.
That's obviously wrong- your actions are evidence of your morality, not the thing that sets it. Now, to do this truly would be nearly impossible, but it is VERY clear that in KOTOR that you see a 'good' option and you actually start to think "Right, that will get me Light Side points, so I will/will not do it", and then suddenly this whole area of subtle development has become just another stat chase. I guarantee you people were doing evil acts just to get more Dark Side points, on the idea they would grow more powerful, and it had nothing to do with the character they were playing.
It also seems that if you have become Mr. Perfect Paladin, you can still commit very evil acts. I know the game doesn't have a schizophrenia setting, but I never felt like I was a good guy, just a person with lots of Light Side points who might change his mind at any point. If you are good, or evil, you should be restricted as such.
2. It actually fails to reflect player choice
This is the killer. The morality system is meant to be the idea that your choice determines your character. In this respect... it is wasting its time.
I think less than one tenth of KOTOR players actually followed the plot through as letting the game guide you through to setting your ultimate morality. Nearly everyone who played decided form the atart "I want to play a Jedi" or "I want to play a Sith" or, in some cases, "I don't really want to be a Force user at all." You then chose the actions each time that best fitted your choice.
The choice had already ben made, from the point you started play- heck, probably the point you bought the game, or earlier.
Hence my original point- people should be free to make the character they want; Mercenary or Force user, Jedi or Sith, and the plot should be tweaked accordingly- similar things have been done before (ironically, even by Lucasarts, doing three different versions of Fate of Atlantis that depended on your style of play), and it can't be more effort than putting in the waste-of-time morality conversations they have before.
Then we would have no more neutral amnesiacs or pickpockets playing at Sith Lords.