Demand for water for environmental uses, such as to provide critical habitat for endangered species, has increased competition for agricultural water supplies. In the western United States, a significant portion of these water demands is to increase in-stream flows. Given that Endangered Species Act (ESA) requirements supersede prior appropriation rights, ESA water demands have the potential to reduce agricultural diversions, particularly in times of drought. This situation occurred in 2001 in the Klamath Basin of southern Oregon and northern California: an ESA-related judicial ruling on the needs of several endangered fish species resulted in a major reduction in water diversions to the Klamath Reclamation Project. Using the Klamath Basin as an empirical backdrop, this study examines the potential benefits and challenges of water banks to mitigate damages to appropriative water rights holders and to provide water for environmental purposes. Results from this case study indicate that water banks are a potentially cost effective way to meet environmental needs. This study, however, illustrated several of the challenges of implementing a water bank given that modifications to the proposed bank are needed to achieve cost efficiency. Specifically, expanded trading is needed, both intraproject and interproject, to achieve the objectives of providing environmental water at minimum cost to society.