Since the height of the credit crisis, U.S. banks have reduced or stopped issuing stock options to employees in favor of so-called restricted stock shares. Like options, the shares cannot be cashed in for several years, but employees can pocket some gains from them even if the stock price falls.

But BNY Mellon is betting options will encourage executives and employees to work hard and be rewarded if its stock price rises.

Still, experts say BNY's contrarian stance could expose the world's largest custody bank to staff departures because executives and rank-and-file employees are more likely to jump ship if the company's stock remains mired at about $22. BNY shares peaked at almost $50 in December 2007.

"This has a very demoralizing effect on employees," said Purdue University professor Ben Dunford, who has studied the impact of underwater stock options on morale.

Competitors that switch to restricted stock could gain an advantage over the bank.

"There's not a lot of appetite for options right now," said Alan Johnson, a top Wall Street pay consultant. "The regulators hate them because they say they encourage excessive risk taking."

BNY employs 48,700 people worldwide and at least two-thirds of their 60.2 million in exercisable stock options were deeply underwater at the end of 2011. About 40 million of the options will expire worthless unless BNY Mellon's share price hits $31, an increase of about 38 percent from the current $22.49.

A group of 10 major U.S. banks and asset managers, including BNY, Goldman Sachs Group Inc (GS.N), JPMorgan Chase & Co Inc (JPM.N) and State Street Corp (STT.N), issued 66 percent fewer options in 2011 than in 2007, according to an analysis of regulatory filings. Employees of the 10 firms have lost nearly $9 billion in paper profits on their options since 2007, according to annual reports.

BNY Mellon was the only company in the group to issue more in 2011 than 2007, granting 8.74 million options compared with 8 million four years earlier. New York-based BNY Mellon declined to comment.

State Street, BNY Mellon's archrival, stopped issuing stock options several years ago and leans heavily on restricted stock in what has become the preferred strategy for many banks.

But BNY's contrarian attitude may yet prove be the right one because it is awarding options when its share price is depressed, Johnson says. Other banks rely too much on restricted stock and should be awarding more options.

"I've been saying that now for two or three years, but on deaf ears," Johnson added.

In its most recent proxy filing discussing executive compensation, BNY Mellon said it reviewed its pay plans to avoid encouraging excessive risk taking. As a result, the bank added some risk-related controls on compensation, such as tying bonuses and restricted stock awards to reaching certain capital levels.

DEMORALIZED EMPLOYEES

Options can produce big gains for employees when a company's stock price rises. They lose all of their value, however, if the stock falls below the price at the time of the award.

Restricted stock continues to grow in popularity at the expense of the "much-maligned stock option," Hofstra University professor Steven Petra and St. John's University professor Nina Dorata wrote last month in the Journal of Accountancy.

Under current accounting rules, restricted stock reduces corporate income less than options. It also is less dilutive to shareholders because they achieve their goal with fewer shares, they said.

BNY Mellon also issues restricted stock, but options remain important. Last month, for example, Chairman and Chief Executive Gerald Hassell received 434,412 options, or 53 percent more than he received in restricted stock, U.S. regulatory filings show.

REPRICING NOT AN OPTION

Even though the Standard & Poor's 500 Index has more than doubled since the stock market's nadir in early March 2009, the financial sector has lagged far behind and most bank-issued options remain underwater. Tens of millions of options have been canceled or forfeited over the past three years as they expired out of the money.

After the dot-com bust, many tech companies repriced their options to keep their talent. But accounting rule changes, such as mandatory expensing along with stricter corporate governance, have made repricing more difficult.

The total intrinsic value of BNY Mellon's outstanding employee stock options, or the paper profits from all in-the-money options, was just $22 million in 2011, down from $875 million in 2007.

Over the past two years, 28.5 million of these employee options have been canceled. That happened largely because BNY Mellon's stock price was below the exercise price when they expired. Options are also canceled if an employee leaves before the vesting date.

(Reporting By Tim McLaughlin; editing by Aaron Pressman, Walden Siew and Andre Grenon)

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