The Office of the Superintendent of Financial Institutions (OSFI) has sent a letter to all federally regulated financial institutions, outlining a number of issues that warrant close attention.

The letter, which was sent on July 7, notes that Canadian household debt levels and real estate prices have reached all-time highs, while interest rates remain low. As a result, OSFI says financial institutions are increasingly vulnerable and need to have adequate processes and controls in place to mitigate their risk.

One area of concern is income verification. The regulator says it is has become aware of incidents where those applying for loans have misrepresented their income or employment, and intends to monitor how financial institutions are managing the issue.

Not sufficiently conservative

"Borrowers relying on income from sources outside of Canada pose a particular challenge for income verification and lenders should conduct thorough borrower due diligence in this regard. 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," reads the letter. "Lenders should not rely on collateral values as a replacement for income verification, especially in areas of Canada where house prices have been rising rapidly."

OSFI is also worried that lenders are not sufficiently conservative when they assess a borrower’s ability to withstand potential financial and economic shocks. The regulator says lenders should be especially careful when considering the resilience of income from rental properties.

Rate higher at renewal

"Relying on the prevailing posted five-year mortgage rate to test a borrower’s ability to service its obligations in a rising interest rate environment does not represent a sufficiently conservative stress test," says OSFI. "Given current exceptionally low interest rates, mortgage lenders should ensure the qualifying interest rate appropriately accounts for the possibility that interest rates could be significantly higher at renewal, and over the full mortgage amortization period."

These are just two highlights from the letter. The complete document is available on the OSFI web site.