Mellon Bank Corp. is facing a tough decision about what to do with a sizable custody servicing contract for its Dreyfus mutual fund family, according to knowledgeable sources.

Officials of Pittsburgh-based Mellon are reportedly interested in assuming control of custody for the $60 billion-asset Dreyfus Funds, which Mellon acquired in August.

But the potential pitfalls of such a change - including the risk of alienating the current custodian, Bank of New York Co. - could keep Mellon from going ahead with the move, said sources close to the matter, who asked not to be named.

A Mellon spokesman said that no decision has been made about a change in the custody contract. Nor has a recommendation been made to the Dreyfus Funds' boards of directors, which would have to approve a change. The spokesman declined to comment further.

But the sources said that Mellon officials are interested in "insourcing" the custody operation to give a boost to a key business line and to improve shareholder service.

A mutual fund custodian is safekeeper of securities that are in the funds and clears and settles trades executed by fund portfolio managers.

Mellon is one of the nation's largest custody banks, with $655 billion in custody. Mutual funds are an important part of this business line, contributing about a tenth of the total assets, the Mellon spokesman said.

Taking the Dreyfus operation in-house would give Mellon's fund custody business a boost. And such a lift would be timely, since Mellon's mutual fund custody business is suffering the loss of a big client. That client, Shearson Lehman Brothers Inc., is in the midst of shifting the custody account for its $46 billion-asset fund family to Mellon's crosstown rival, PNC Bank Corp.

Also, taking custody in-house would let Mellon keep fees that are now being paid to a rival. With about $290 billion of mutual fund assets under custody, Bank of New York is the second-largest mutual fund custodian after State Street Boston Corp.

Furthermore, insourcing custody would not be unusual for a bank. Of the 119 banks that run mutual funds, nearly half act as their own custodian, according to Lipper Analytical Services Inc., Summit, N.J.

Banks, in this regard, are decidedly different from nonbanks, which almost never act as their own custodians.

But the sources added that if Mellon were to take over the custody contract, it could be a costly move. Namely, it could push Bank of New York to stop using Dreyfus funds for its cash management needs.

The sources were quick to explain that no quid pro quo exists. In other words, Bank of New York is not using Dreyfus Funds as a reward for the custody contract.

But, the sources added, if Mellon were to end the custody contract, it could alienate Bank of New York so much that officials of the bank might decide to move some or all of their cash management money to other mutual funds. Such a decision would be easy to justify and to execute in the competitive cash management business.

Additionally, the sources said that many Dreyfus officials like working with Bank of New York. So a change in custodians could alienate some key back-office employees at Dreyfus.

The custody contract is not the only back-office issue under evaluation at Dreyfus. There also have been discussions about changing a transfer agency contract, a knowledgeable source said.

Currently, Mellon uses Shareholder Services Group, a Boston-based unit of First Data Corp., as transfer agent. In this capacity, Shareholder Services' employees and computers maintain records of Dreyfus fund shareholders and share values.

A source close the Dreyfus funds said that Mellon officials have discussed bringing more of these operations in-house as a money saving move. One option under consideration is putting the Shareholder employees who now operate the shareholder servicing system in a facility in Providence, R.I., onto Mellon's payrolls.

But the source added that no decision has been made. The Mellon spokesman said that Mellon, as a matter of policy, could not comment on "something as speculative as that."

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