Canada’s top banking regulator is stepping up expectations for banks when it comes to mortgage lending.

The Office of the Superintendent of Financial Institutions issued a four-page letter to financial institutions Thursday spelling out the regulator’s expectation for mortgage lending practices — including income verification.

“OSFI is aware of incidents where financial institutions have encountered misrepresentation of income and/or employment,” said the letter signed by Superintendent Jeremy Rudin, which warned that borrowers who rely on income from sources outside of Canada “pose a particular challenge for income verification.”

The letter told the lenders to conduct thorough borrower due diligence in such cases.

“Income that cannot be verified by reliable well-documented sources should be treated cautiously when assessing the ability of a borrower to service debt obligations,” OSFI told the banks.

Home Capital Group Inc., one of Canada’s largest alternative lenders, cut ties with 45 mortgage brokers last year after a tip led to an internal probe that revealed falsification of income information had occurred.

In Thursday’s letter, OSFI told all mortgage lenders they should not rely on collateral values as a replacement for income verification, especially in areas of Canada where house prices have been rising rapidly.

“Persistently low interest rates, record levels of household indebtedness, and rapid increases in house prices in certain areas of Canada (such as Greater Vancouver and Toronto), could generate significant loan losses if economic conditions deteriorate,” the regulator warned, adding that financial institutions can sustain losses both through the inability of borrowers to meet their debt obligations, and through declining values of the real estate properties pledged as collateral in mortgage loans.

A spokesperson for federal finance minister Bill Morneau said OSFI’s letter is “consistent with the minister’s own actions to address pockets of risk in Canada’s housing market.”

Daniel Lauzon, Morneau’s director of communications, said new measures came into effect this week, including amendments that clarify how government-backed insured mortgages can be securitized.

Lauzon said a working group of federal, provincial, and municipal officials in Canada’s hottest housing markets of Vancouver and Toronto is being convened this summer to review the affordability and stability of the housing market.

In the letter sent to financial institutions Thursday, Rudin said banks should not be assessing a borrower’s ability to service debt based on current “exceptionally low” interest rates, and warned them not to become lax in processes such as income verification if a mortgage meets the regulators loan-to-value caps.

“The 65% LTV (loan to value) threshold used in OSFI Guideline B-20 should not be used as a demarcation point below which sound underwriting practices and borrower due diligence do not apply,” the regulator warned.

OSFI told the banks to assume interest rates could be “significantly higher at renewal, and over the full mortgage amortization period.”

Rudin’s letter urged federally regulated financial institutions including the country’s biggest banks to identify residential mortgages that exhibit the highest risk characteristics. These mortgages demand “greater due diligence of the borrower and stronger internal controls,” Rudin said.

A report from Moody’s Investors Service published last month said a U.S.-style housing meltdown with house prices falling by as much as 35 per cent could cost Canadian banks and mortgage insurers $17 billion. Though they would be able to weather such a downturn, the ratings agency warned that it would expose “systemic vulnerabilities” in the system.

The report warned that mortgage loans in a segment of the market subjected to less regulatory scrutiny could trigger downward pressure on surrounding housing prices. Moody’s estimates this group of lenders, which slipped through the regulatory cracks and does not face the tighter underwriting standards imposed on deposit-taking banks and some credit unions, accounts for about six per cent of Canada’s $1.6 trillion mortgage market.

Jason Mercer, the lead author of the Moody’s report, said OSFI’s letter Thursday signals that the regulator is “intensifying” its examination of residential mortgage underwriting.

“It’ll force the banks to maintain or enhance existing residential mortgage underwriting controls amid growing concerns of increasing household debt and elevated housing prices,” Mercer said.

While lenders can play a role in calming what many believe is a frothy real estate market, the top executive at one of the Canada’s largest banks has called on Ottawa to do more. Bank of Nova Scotia chief executive Brian Porter suggested in a television interview last month that the bank would be in favour of higher down payment levels.

Canada’s Top Banking Regulator Tightens Scrutiny of Mortgage Lending Practices Amid Soaring Home Prices by Barbara Shecter | Financial Post