Embedding Water‑related Risks in Financial Stability Frameworks

5. Aligning financial supervision with enabling policies to manage water-related risk

Abstract

Given the local and global nature of water-related risks and the forces shaping financial flows, there is need for alignment between domestic policies and international standards. Real economy and environmental policies influence water use, pricing, and ecosystem resilience at the national level. International rules governing investment and sustainable finance shape the availability and comparability of information on water-related risks and ultimately influence how capital is allocated across the global financial system.

This chapter outlines the levers available to financial authorities, while highlighting the need for coherent investment policies across the regulatory ecosystem. It also emphasises the foundational role of mainstreaming water consideration across policymaking and the importance of cross-sector collaboration in managing systemic water-related risks.

5.1. There are many leverage points for addressing risks in the financial system

The financial consequences of water-related risks do not arise only at the point of ecosystem collapse. The accumulation of pressures, from groundwater depletion to declining water quality, can disrupt productivity and trigger financial distress long before ecosystems reach tipping points. In turn, companies that drive water degradation may be increasing their own exposure to financially material transition and liability risks.

For financial institutions and authorities, assessing the financial materiality of water-related risks is a matter of judgment and assessment. It cannot rely solely on static quantitative thresholds but must instead consider the context-specific exposure and vulnerability of activities, including their geographic location and adaptive or absorptive capacity, to current and potential future water-related hazards and trends.

The financial system has multiple channels through which water-related risks can be assessed and managed. These include:

• Macroprudential and microprudential supervision can embed water-related risks into risk identification frameworks, scenario analysis, and stress testing. While macroprudential tools help ensure system-wide resilience and adequate capital buffers in the face of hydrological shocks, microprudential supervision ensures that individual financial institutions integrate material water-related risks into their governance, risk management, and internal controls.

• At the institutional level, financial actors can adopt water-sensitive risk management tools, including diversification, hedging, or ESG integration strategies, for instance, tilting portfolios toward entities with strong water stewardship (OECD, 2020[1]).

• At the transaction level, mechanisms such as insurance, de-risking facilities, or shareholder engagement can help reduce exposure to water-related risks. Where risks remain unmanageable, divestment from high-risk regions or sectors may be necessary, albeit as a last resort (Davies and Martini, 2023[2]).

Importantly, these tools function within a broader regulatory and policy ecosystem. Investment regulation, including corporate disclosure mandates, sustainable finance taxonomies, and due diligence obligations, play a key role in enabling and reinforcing prudential oversight. These frameworks support financial supervisors and institutions by establishing clear definitions of sustainability, improving data availability and comparability, and enhancing the traceability of environmental risks along global value chain (UNEP FI and WWF, 2024[3]).

A better understanding of water-related financial risks, including dependencies, impacts, and potential transmission channels, can motivate early action to mitigate risks and enhance resilience. It can also help redirect investment towards emerging opportunities in water-efficient technologies, sustainable infrastructure, and resilient supply (CDP, 2023[4]).

Still, there is an important distinction between managing water for environmental security and managing water for financial stability. While often aligned, the objectives, tools, and incentives are not the same. Importantly, while environmental policies to enhance water security are essential for long-term economic resilience, they may also introduce short- and medium-term financial risks for firms operating in water-intensive sectors. Changes in water pricing, pollution controls, abstraction limits, or conservation measures can influence operational costs, credit risk profiles, and investment strategies, with implications for financial markets and financial supervision (see Chapter 3).

In short, while managing water-related risks for environmental security and managing water-related risks for financial stability may have a common goal, these are distinct objectives that are not systematically aligned. Policymakers, financial supervisors, and financial institutions all have a role to play in bridging this gap. The following sections explores how central banks and supervisors are responding to this challenge, and where investment regulation and real economies policies are also critical.

5.2. Central banks can integrate water-related risks into monetary and supervisory policy

Financial authorities can act through multiple channels: by embedding water-related risks into supervisory frameworks, adjusting monetary policy operations to reflect environmental shocks, and leading by example through the management of their own balance sheets. This section outlines the principal levers available within their mandates, focusing on three main domains: banking supervision, monetary policy implementation, and management of central banks’ own accounts.

5.2.1. Supervisors can embed water into banking oversight and risk frameworks

As climate and nature-related risks gain prominence, financial supervisors are beginning to integrate these considerations, relevant for freshwater-related risks, into banking regulation and oversight. Although still emerging, supervisory frameworks are evolving to reflect the materiality of climate and nature risks through tools for capital adequacy assessment, disclosure, and market discipline. While this section focuses on banking, water-related risks are also highly relevant to insurers and non-bank financial institutions.

Basel III, introduced by the Basel Committee on Banking Supervision (BCBS) in response to the 2008 financial crisis, updated earlier frameworks to improve capital adequacy and systemic resilience. The Basel III framework remains central to global prudential regulation, offering key entry points for integrating water and nature-related financial risks, particularly through Pillar 2 (supervisory review) and Pillar 3 (market discipline) (UNEP FI and WWF, 2024[158]). The three-pillar structure comprises:

• Pillar 1: Minimum regulatory requirements for capital adequacy, liquidity, and leverage;

• Pillar 2: Supervisory review process for assessing banks’ capital adequacy, internal risk management and risk governance;

• Pillar 3: Market discipline through public disclosure of key risk exposures and risk management practices.

As international standards developed by consensus among member countries, these standards do not automatically have legal force. This means that each country’s regulatory authorities (e.g., central banks or financial regulators) are responsible for turning the agreed standards into legally enforceable domestic rules and have some margin for interpretation, notably with respect to climate and nature risks.

Climate-related financial risk regulation is comparatively advanced, with respect to guidance with many jurisdictions establishing supervisory expectations and disclosure requirements. The maturity of regulatory approaches ranges from high-level voluntary guidance to detailed supervisory expectations and, in some regions, binding rules (FSB, 2024[100]).

Supervisory expectations under Pillar 2 require banks to identify, assess, and manage all material risks. Many climate risk guidelines are beginning to expand in scope to cover broader environmental risks. For instance, the ECB’s guidance, while focused on climate, also refers to “environmental risks” and the ECB’s ongoing supervisory review explicitly checks whether banks incorporate both climate and broader environmental risks into strategies and risk management (FSB, 2022[222]).

A number of other authorities have issued high-level guidelines on climate and environmental risks management that encompass nature-related risks (some examples are in Box 5.1). For illustration, the Dutch National bank (DNB), the China Banking and Insurance Regulatory Commission (CBIRC), and others have released guidance for banks and insurers to manage environmental and climate risks in tandem (Box 5.1)(FSB, 2024[100]). Typically, these guidelines integrate nature-related risks alongside climate risks under the broader ESG risk umbrella. However, they often note that guidance on biodiversity and ecosystem risks remains less detailed than for climate risks at this stage​ (FSB, 2024[100]). For instance, DNB’s 2023 guidance on managing climate and environmental risks explicitly covers nature-related financial risks but provides fewer concrete examples for biodiversity loss than for climate change​ (FSB, 2024[100]).

A notable example of innovative supervisory measures to address environmental risks is the Hungarian Central Bank’s (MNB) Green Preferential Capital Requirement Programme. As the only central bank worldwide currently applying a targeted green supporting factor under Pillar 2, the programme incentivizes banks to extend credit for verified green projects by allowing reduced capital requirements for such exposures. Evidence from the programme demonstrates that green firms tend to present lower credit risk, supporting the prudential rationale for differentiated capital treatment. Box 5.2 provides a detailed overview of the programme’s design and key findings.

Box 5.1. Examples of climate and environment integration in supervisory review (Pillar 2)

Europe

European regulators have been early movers in embedding climate considerations into Pillar 2. The ECB issued its Guide on climate-related and environmental risks in 2020, setting supervisory expectations for banks under its watch (Euro Area significant institutions) to integrate these risks into governance, risk management, stress-testing and disclosure​. While the ECB guide is formally non-binding, it has been used in the Supervisory Review and Evaluation Process (SREP) – meaning banks are assessed against these expectations.

The ECB explicitly addresses water stress, water pollution, overexploitation, droughts, and floods in its 2020 Climate and Environmental Risk Guide and 2022 compendium of good practices. Banks under ECB supervision are required to assess the materiality of water-related risks, integrate them into risk appetite frameworks, and adapt risk management tools, including due diligence policies, client engagement strategies, and loan pricing mechanisms.

By 2022–2023, the ECB had conducted a “thematic review” of climate and environmental risk management at banks and found many shortcomings. As a result it has started to impose supervisory measures (e.g., capital add-ons or qualitative requirements) for banks that fall short of the expectations.

Thematic reviews indicate that banks in Europe are developing their climate and nature risk management capabilities at a rapid pace. Over 85% of banks now meet at least basic supervisory expectations for climate and environmental risk integration. Future supervisory efforts will focus on monitoring remediation plans, sharing best practices, and improving transparency through frameworks such as the Corporate Sustainability Reporting Directive (CSRD) and the European Financial Reporting Advisory Group (EFRAG).

The ECB has set a 2024 compliance deadline, requiring banks to include climate and environment risks (including water) in stress testing and capital adequacy frameworks, with enforcement actions ranging from supervisory dialogues to binding requirements.

Germany

Germany's integrated financial regulatory authority (Bundesanstalt für Finanzdienstleistungsaufsicht or “BaFin”) updated its prudential guidance (MaRisk Circular 05/2023), effective June 29, 2023. This revision incorporates explicit expectations for institutions to integrate environmental, social, and governance (ESG) risks into their risk management frameworks. Specifically, institutions are now expected to assess their ESG risks using scientifically based, forward-looking scenarios, ensuring a comprehensive understanding of potential impacts from environmental factors such as deforestation and water stress.

While BaFin does not mandate specific limits on exposures to environmental risks, it emphasises the importance of institutions independently evaluating and managing these concentrations. This approach underscores the accountability of banks to identify and address material environmental risk hotspots, such as significant reliance on water-intensive sectors, that could threaten financial stability. ​

The revised MaRisk also clarifies that institutions should measure their sustainability risks using scientifically based scenarios. This guidance aims to ensure that banks do not rely solely on internal assumptions but instead incorporate objective, science-driven analyses into their risk management practices.

This approach reinforces accountability for banks to identify material environmental risk hotspots (such as heavy reliance on water-intensive sectors) that could threaten stability.

Source: (UNEP FI and WWF, 2024[158]; ECB, 2022[223]; Nitschke, 2023[224]; ECB, 2020[205]).

Box 5.2. The Green Preferential Capital Requirement Programme in Hungary (Pillar 2)

The Magyar Nemzeti Bank (MNB) launched its Green Preferential Capital Requirement Programme in January 2020, making it the first central bank globally to introduce a targeted green supporting factor under Pillar 2 of the supervisory framework. Under the programme, banks can apply for reduced capital requirements for exposures that meet MNB-defined green criteria, primarily energy efficiency, renewable energy, and environmentally sustainable construction projects.

Green projects are rigorously classified according to a taxonomy developed by MNB, and banks must demonstrate adherence to environmental standards throughout the loan lifecycle. The programme is designed to stimulate green lending in the Hungarian banking sector by lowering the cost of capital for banks that provide credit to green projects, thereby mobilising private finance for Hungary’s climate objectives.

Key findings from Preferential Capital Requirement Programme

• Loans associated with green projects exhibit significantly lower credit risk than non-green counterparts, even after controlling for sector, borrower, and collateral type.

• The reduced risk profile of green firms holds consistently across portfolio segments, supporting the supervisory logic behind the green supporting factor.

• Most projects to date have targeted energy efficiency and renewable energy, but the working paper indicates potential to diversify into broader nature-related (e.g., water, biodiversity) investments.

The MNB is now assessing pathways to expand the scope of the programme, aiming to incentivise more diverse nature-friendly lending, bridging climate and biodiversity objectives and anchoring environmental considerations in prudential regulation.

Source: (Bálint Várgedő, Csaba Burger and Donát Kim, 2025[225]).

Likewise, under Pillar 3, disclosures are evolving to require more detailed information on environmental and climate-related risks, helping both supervisors and markets evaluate banks’ environmental risk profiles. Enhanced disclosure is intended to strengthen market discipline by enabling investors and stakeholders to better assess how environmental risks are managed and priced. Increasingly, supervisory authorities and standard-setters such as the NGFS are emphasising the need for banks to enhance transparency around their exposure to environmental and climate-related risks, including water-related vulnerabilities (NGFS, 2021[226]).

Under Pillar 2, supervisory review, there is the potential for authorities to strengthen requirements to assess water-related risks - both physical risks (e.g., water scarcity, drought, and flooding) and transition risks linked to the shift toward more sustainable, water-efficient economies. Under Pillar 3, prudential disclosure, enhanced disclosure of metrics (e.g., assets in water-stressed regions or clients’ water dependency) could help to reveal concentrations of risk and incentivise banks to mitigate those risks.

Despite growing attention, the integration of climate- or nature-related risks under Pillar 1 remains limited. While capital and reserve requirements can, in theory, incentivise banks to manage climate and nature risks more effectively, methodological challenges persist in quantifying and calibrating water-related risks. Achieving a significant impact on financing and investment decisions may require very high capital and reserve requirements, which could potentially hinder economic activity (Bank of England, 2021[227]). Moreover, while substantial methodological work is being conducted, there is no commonly accepted approach to isolate the quantitative effects of nature-related risks on regulatory capital requirements (IMF, 2024[61]).

Box 5.3. Example of climate and environment integration in public disclosures (Pillar 3)

Brazil

In Brazil, regulatory initiatives are increasingly aligning with Pillar 3 of the Basel Framework by promoting transparency in environmental risk disclosures within the banking sector. The Central Bank of Brazil (Banco Central do Brasil – BCB) has implemented measures to ensure that financial institutions systematically assess and disclose their environmental risk exposures.​

Banks are mandated to publish annual sustainability reports that detail their social and environmental risk management practices. These reports often include disclosures on exposure to sectors with significant environmental impacts, such as mining and agribusiness, which are associated with biodiversity risks. This practice enhances market discipline by providing stakeholders with critical information on banks' environmental risk profiles. ​

Introduced by the BCB through Resolution No. 151/2021 and Normative Instruction No. 222/2021, the DRSAC (Social, Environmental, and Climate Risk Document “DRSAC”) framework requires financial institutions to systematically collect and report data on their exposure to social, environmental, and climate-related risks. This includes information on clients' deforestation risks, water usage, and other environmental impact factors. While primarily designed for supervisory purposes, the DRSAC framework is expected to lead to more comprehensive public disclosures, thereby reinforcing market discipline and informing stakeholders about the environmental risk exposures and mitigation strategies of financial institutions.

Recent updates (April 2024) to DRSAC (renamed GRSAC) have increased its alignment with International Sustainability Standards Boards (ISSB) standards, which will likely increase public disclosure (even if originally designed for supervisors).

Source: (Stussi, Souza and Contreras, 2024[228]; Costa, 2024[229]).

Globally Systemic Banks

Systemically important banks, known as global systemically important banks (G-SIBs), are the largest and most interconnected financial institutions in the world. Because of their size, complexity, and global reach, distress at a G-SIB can have outsized effects on the entire financial system. As such, G-SIBs are subject to additional regulatory requirements under the Basel III framework, including higher capital buffers determined by their “bucket allocation.” Bucket allocation is the process by which G-SIBs are categorised into different risk buckets according to indicators such as size, interconnectedness, and complexity, with each bucket corresponding to a required capital surcharge.

Recent analysis, including that conducted by WWF and CDP, has highlighted the importance of reviewing these Basel III components to ensure that G-SIBs adequately account for water and nature-related financial risks (WWF and CDP, 2024[16]). For instance, bucket allocation methodologies could be revised to explicitly reflect a bank’s exposures to water-stressed sectors or regions, recognising that these exposures can amplify systemic risk. Enhanced risk disclosures and internal risk management expectations for G-SIBs would complement these measures.

In practice, several leading G-SIBs are already mapping their portfolio dependencies on water and have begun to set limits or increase due diligence for clients operating in high water-risk regions. Strengthening G-SIB regulation to reflect water and nature risks would not only improve global financial system resilience, but also drive best practices throughout the sector (WWF and CDP, 2024[16]).

5.2.2. Monetary policy frameworks can adapt to environmental shocks

By recognising the potential long-term implications of climate change and nature degradation for macroeconomic stability, central banks can take steps to ensure that their monetary policy operations remain consistent with the goals of a sustainable economic transition. This may include integrating climate-related variables into inflation forecasting or adjusting operational frameworks to support investment in green or climate-resilient sectors (ADBI, 2018[17]).

However, there is ongoing debate about the appropriate scope of monetary policy in addressing environmental risks. While there is broad consensus on the importance of providing climate-related data, enhancing modelling capacity, and supporting orderly transitions, views diverge on whether central banks should take a more active role in steering capital flows toward green investments. Some institutions have adopted green finance policies or guidelines within their mandates, while others express caution, citing potential distortions and risks of market interventionism (Murphy, 2023[18]).

Notably, the theoretical and empirical foundations for integrating climate and nature-related risks into monetary policy remain underdeveloped. Initial research suggests that green monetary interventions could generate trade-offs with traditional objectives such as price stability and central bank independence, particularly if applied at scale or without strong complementary policies (NGFS, 2021[19]).

Nevertheless, some central banks are already adjusting their operational frameworks to better reflect the financial risks posed by environmental hazards. These actions are typically framed not as green policy activism, but as prudent risk management aligned with existing mandates.

Collateral frameworks: adjusting monetary operations for water-related risk

As the financial impacts of environmental risks become clearer, central banks are under growing pressure to adapt their operational frameworks. Collateral frameworks are a central part of monetary operations. Acting as lenders of last resort, central banks provide liquidity to financial institutions by accepting collateral in exchange for reserves. To manage the associated risks, central banks use collateral frameworks that specify eligible assets and apply haircuts, which are reductions in the asset’s value to buffer against potential losses (Cahn et al., 2018[20]; ECB, 2023[21]; ECB, 2020[9]).

Recent research highlights that nature- and water-related risks remain largely unaddressed in central bank collateral frameworks (Dafermos and Gabor, 2022[22]; Abdelli, Batsaikhan and Carella, 2024[23]). For example, Banque de France’s collateral pool is exposed to significant nature risks. Specifically, for sectors such as food and beverage, healthcare, materials, and real estate, surface and groundwater are identified as some of the most vital ecosystem services in terms of both average and critical dependency, for both direct and upstream activities. Yet, this not reflected in collateral frameworks (Abdelli, Batsaikhan and Carella, 2024[23]).

In this context, the Bank of England’s integration of flood risk into its mortgage collateral framework represents a significant development. Rather than attempting to direct capital toward green outcomes, the Bank of England’s action is a targeted response to growing evidence that environmental hazards can materially affect asset values (Box 5.4). This approach underscores the growing relevance of nature-related risks to financial stability, and the capacity of central banks to respond with proactive, risk-based policy tools.

Box 5.4. The Bank of England’s treatment of residential mortgage collateral

Collateral haircuts are a core component of central bank risk management. When banks borrow from central banks, they pledge assets as collateral. To protect against a potential drop in asset value, central banks apply a haircut (i.e. a percentage reduction in the collateral’s value). This buffer is designed to safeguard the central bank from losses in the event of a borrower’s default and declining collateral prices. If environmental risks such as flooding impact asset values, failing to reflect them in haircut levels could leave central banks exposed.

Recognising this vulnerability, the Bank of England in August 2024 updated its treatment of residential mortgage collateral within the Sterling Monetary Framework, which is the operational framework used by the Bank of England to implement monetary policy and ensure financial stability in the UK. The updated policy integrates flood risk into several key dimensions of collateral assessment:

• Loss-given-default calculations, to reflect the greater loss severity associated with flood-damaged properties;

• Collateral valuation adjustments, incorporating future devaluations due to flood exposure; and

• Haircuts, which are increased for high-risk properties based on granular risk modelling.

The Bank of England’s modelling draws on forward-looking flood risk projections, including estimates of future insurance premium increases and the potential for certain properties to become uninsurable following the planned phase-out of the UK’s Flood Re scheme in 2039. In the most flood-prone areas, the Bank projects that property values could fall by as much as 20%, raising the risk of borrower default and collateral shortfalls.

This move marks a pivotal shift toward integrating climate and water-related physical risks into monetary operations. Rather than treating environmental shocks as externalities, the Bank of England is adjusting its frameworks to reflect the real economic impact of environmental degradation.

Note: FloodRE is a UK government-backed reinsurance scheme that helps make flood insurance more affordable and widely available for homes at high risk of flooding by sharing the cost of flood claims across the insurance industry.

Source: (Bank of England, 2024[24]).

Monetary policy implementation and reserve management with sustainability objective

While central banks have traditionally focused on price stability and financial system liquidity, growing environmental risks are prompting a reassessment of how monetary policy tools might also support long-term economic and financial resilience. In this context, there is potential for monetary policy tools to be adapted, with the scope of respective central bank mandates, to support environmental resilience alongside financial stability objectives.

One avenue is through green credit allocation tools, such as targeted refinancing windows, preferential rediscount rates, or sustainability-linked lending programmes. These tools can incentivise financial institutions to allocate credit towards sectors that advance water efficiency, conservation, or pollution control. For example, Bangladesh’s Green Transformation Fund provides refinancing for imports of environmentally friendly machinery in export sectors, such as textile manufacturing (Bangladesh Bank, 2020[25]). By offering concessional rates to priority sectors, central banks can indirectly steer bank lending towards water-resilient investments.

Rediscount rates may also be differentiated based on counterparty risk profiles or environmental dependencies, thereby embedding water-related risk pricing into monetary operations. In some cases, lending quotas can mandate that a minimum share of credit flows to climate- and nature-related sectors, including water-friendly projects.

Sustainability-oriented reserve management can represent another pathway to meeting sustainability objectives. Traditionally, central banks manage foreign exchange reserves with a focus on liquidity, safety, and return. However, there is growing interest in integrating climate risk into reserve management strategies (Climate Bonds, 2024[26]). Similarly, central banks could, for instance, assign risk weightings to sovereign or corporate bonds based on water stress exposure or governance. This would allow central banks to favour issuers from regions with strong water stewardship and disincentivise investments in high-risk, unsustainable regions. While this can create a financial incentive for improved water governance, restricting capital to water-stressed regions may undermine their ability to invest in water security. A more nuanced approach would reward regions with credible water transition plans or investment in water infrastructure, rather than penalising current stress alone.

A key constraint is the need for more robust analysis on the potential trade-offs between environmental objectives, such as improving water resilience, and traditional central banking mandates, particularly price stability. More empirical and theoretical work is needed to understand how interventions might interact with inflation dynamics, credit conditions, and long-term growth, as well as with other social and environmental objectives. Monetary authorities also often lack granular, timely, and spatially explicit information on how water-related risks affect key macroeconomic variables such as inflation, employment, and output. Most water-related risks are highly localised, making it difficult to translate them into aggregated national-level indicators that central banks typically rely on.

In addition, institutional mandates and legal frameworks often restrict central banks from actively pursuing environmental objectives unless they pose a clear threat to price or financial stability. This creates uncertainty around how far central banks can go in adapting tools such as interest rates, collateral frameworks, or refinancing operations to address water-related risks. Without clear analytical models, robust datasets, and political consensus, monetary authorities may be hesitant to incorporate water-related risk considerations beyond research and early-stage scenario analysis.

5.2.3. Leading by example: managing water-related risks in central bank portfolios

Central banks have become the largest asset owners of advanced economies since the 2007-2008 financial crisis. They are therefore exposed to the same risks as other asset owners. Asset managers are also exposed to the consequences of higher perceived or real risks in their portfolios by their clients. When water-related risks materialise, clients may ask to sell-off related assets, which may lead to a decrease in valuation and financial performance (OECD, 2021[27]).

Recognising these exposures, central banks are beginning to incorporate climate and nature-related risks, including water-related risks, into the management of their own accounts. This is not only prudent risk management, but also an opportunity to lead by example. By applying emerging disclosure and risk assessment frameworks to their own portfolios, central banks can signal the importance of integrating environmental risks across the financial system and contribute to collective learning on new methodologies.

For example, the Dutch Central Bank conducted a TNFD framework to its investment portfolios. The initiative aimed to assess nature-related financial risks, gain experience with the TNFD framework, and contribute to global capacity building. The study analysed two developed market equity portfolios—one actively managed (Paris Aligned Mandate) and one passively managed (Broad Market Portfolio), as described further in Box 4.4.

Findings showed that while TNFD tools like ENCORE and the WWF Biodiversity Risk Filter provided useful insights, the process was labour-intensive and limited by the paucity of location-specific data. A key takeaway was the value of starting with a smaller scope before scaling up, allowing for manageable complexity. The study also emphasised the need for capacity building, knowledge sharing, and location-based analysis to better engage with external managers on water-related risks (DNB, 2023).

By experimenting with frameworks such as TNFD, central banks can help develop best practices, improve data and methodology, and build institutional capacity for assessing freshwater-related risks. These efforts can send strong signals to markets and financial institutions, reinforcing supervisory guidance and accelerating the integration of nature and water into financial decision-making.

While these supervisory and monetary tools are essential, they cannot stand alone. Their effectiveness ultimately depends on a supportive policy environment, one that governs how water is valued, allocated, and stewarded across the economy. The next section explores how this enabling ecosystem, spanning investment regulation, corporate disclosure, and real economy policies, can reinforce financial resilience while advancing water security.

5.3. Better water policies can strengthen financial resilience

Managing water-related risks should be understood not only as an environmental necessity but also as a financial and economic imperative. The increasing frequency and severity of water stress, pollution crises, and ecosystem degradation will have cascading effects on economic stability, investment flows, and financial risk.

It is important to distinguish the financial regulators’ mandate from broader environmental and water management objectives. Central banks and supervisors focus on managing the financial risks stemming from water-related challenges, to ensure that banks remain resilient to, for instance, a drought-induced default surge or flood damage to assets. Protecting the banking sector and economy from shocks transmitted via water stress is fundamentally a financial stability mission.

Alongside prudential measures, there are a number of other policies which are critical to supporting these objectives including the role of regulation and policies that oversee investments, including notably disclosure regulation, taxonomies and due diligence, which can influence risk management practices, the availability of data on exposures, and the alignment of investments with environmental objectives. In addition, at the basis of the pillar, real economy policies have a critical role in shaping resilient economies.

5.3.1. Water security is built through real economy foundations

Achieving water security (e.g. guaranteeing sustainable water supply, quality, and access for all users) is beyond the remit of central banks. The OECD definition of the management of water-related risks to achieve water security is defined as achieving and maintaining acceptable levels for four inter-related water-related risks: too little water (scarcity and droughts), too much water (floods), too polluted water (lack of suitable quality water for a particular purpose), and degradation of freshwater ecosystems. This is also linked to managing access to safe water supply and sanitation. Limited access further exacerbates and is further exacerbated by water-related risks (OECD, 2022[28]).

Water security is principally the responsibility of governments, water authorities, and environmental policymakers through investments in infrastructure, effective water governance, and resource management. As the OECD notes, public water policies and management practices directly determine the water security of regions and thereby influence the magnitude of water-related financial risks. For instance, better watershed management or climate adaptation projects can reduce the probability of water crises, in turn lowering credit risks for banks exposed to affected communities.

Central banks mandate lies in ensuring that banks and the financial system remain resilient as water-related risks unfold, through prudential supervision, scenario analysis, and capital frameworks. Sustainability outcome, such as infrastructure investments or pollution regulation, fall under the remit of environmental and water authorities. This distinction helps ensure that each actor contributes within its domain while supporting systemic resilience (Bolton et al., 2020[29]).

Central banks play a critical role in signalling when environmental degradation escalates into a systemic financial risk. As water stress, pollution, and freshwater ecosystem loss intensify, their impacts on productivity, inflation, and financial system stability become more pronounced. While environmental management is outside their direct remit, central banks can assess and communicate when such risks threaten macroeconomic and financial resilience, helping policymakers prioritise action. The concept of “transformative change,” as defined by the Intergovernmental Science-Policy Platform on Biodiversity and Ecosystem Services (IPBES), refers to a “fundamental, system-wide reorganisation across technological, economic and social factors, including paradigms, goals and values, needed for the conservation and sustainable use of biodiversity, long-term human wellbeing and sustainable development” (IPBES, 2019[30]). Central banks’ analytical capacity and system-wide view mean they can contribute to this process by elevating issues within government agendas, enabling policymakers to prioritise structural reforms and investment in water resilience. This signalling function is especially important where risks may be accumulating invisibly and where proactive public policy responses are needed to mitigate cascading impacts across the economy and financial system.

5.3.2. Investment regulations can clarify risks and sustainability thresholds

To support supervisory integration of water-related risks, investment regulations and market infrastructure must evolve to improve data and risk transparency. Prudential regulation operates within a broader regulatory and policy ecosystem. Its effectiveness in addressing nature-related financial risks, including those linked to water, depends on complementary frameworks that shape how risks are measured, disclosed, and governed across the financial system. As financial institutions seek to integrate environmental and nature-related considerations into their risk management, non-prudential regulation plays a foundational role in enabling and reinforcing prudential oversight.

Key among these enabling frameworks are sustainable finance taxonomies, corporate disclosure requirements, and due diligence obligations. These tools support financial supervisors and institutions by establishing clear definitions of sustainability, improving data availability and comparability, and enhancing the traceability of environmental risks along global value chains. When aligned, they enhance the ability of financial institutions to assess and manage material exposures, while allowing prudential authorities to set supervisory expectations on a consistent, risk-based basis (UNEP FI and WWF, 2024[3]).

While each of these policy instruments serves a distinct purpose, their effectiveness is mutually reinforcing. Coherence and interoperability across jurisdictions are critical. Diverging standards can create regulatory fragmentation and undermine comparability of disclosures, particularly for globally active financial institutions. This regulatory inconsistency is increasingly recognised as a barrier to effective nature-related risk management. Misaligned or conflicting frameworks can lead to inefficiencies and regulatory uncertainty, whereas aligned approaches support more robust risk identification, reduce supervisory blind spots, and enable financial actors to respond to emerging environmental challenges with greater clarity and confidence (UNEP FI and WWF, 2024[3]).

The supervisory value of corporate reporting

Robust corporate disclosure rules are essential for financial supervisors to assess water-related financial risks. Frameworks like the EU’s Corporate Sustainability Reporting Directive1 (CSRD) and the International Sustainability Standards Board (ISSB) standards2 require companies to disclose material sustainability risks and impacts, providing critical data for financial institutions and regulators. Under CSRD, companies must report metrics such as water consumption, water stress exposure, and pollution events (ESRS E3), applying a double materiality lens. By contrast, ISSB (IFRS S1 and S2) focuses on enterprise value and financial materiality. Together, these frameworks improve transparency and comparability across jurisdictions.

However, implementation challenges persist. The EU’s 2024 Omnibus Directive3^, adopted in 2025, raises the CSRD reporting threshold to cover only firms with more than 1 000 employees and delayed timelines by two years, potentially excluding many mid-sized firms from mandatory water-related risk disclosure. While aimed at reducing reporting burdens, such changes will weaken transparency at a time when water-related risks are becoming more systemic.

Disclosure frameworks directly support prudential oversight. Supervisors and banks rely on company-level data to evaluate exposure to physical water-related risks and assess risk management. For example, disclosures on water stress at industrial sites help identify elevated credit or operational risks. The European Banking Authority has explicitly recommended that banks integrate information from sustainability disclosure frameworks like CSRD into their internal risk assessments (EBA, 2025[31]). Enhanced disclosure also enables scenario analysis, stress testing, and sector benchmarking based on firms’ real water-related risk profiles. Moreover, it improves corporate behaviour and accountability by creating transparency for investors and civil society. Going forward, aligning disclosure standards across jurisdictions (e.g. CSRD and ISSB), and integrating emerging nature-focused frameworks such as the Taskforce on Nature-related Financial Disclosures (TNFD), will be key to ensuring water-related risk data is comprehensive, reliable, and useful to support decisions by financial supervisors (TNFD, 2024[32]).

Taxonomies as a risk and opportunity lens

Sustainable finance taxonomies are classification systems defining which economic activities are environmentally sustainable. Their primary purpose is to create a common language for green investments, guiding capital towards activities that substantially contribute to environmental objectives while avoiding significant harm. The EU Taxonomy, established by the Regulation (EU) 2020/8524, serves as a cornerstone of the EU’s sustainable finance framework designed to channel investment to activities needed for climate and environmental goal. To qualify, an activity must not only contribute to one objective (e.g. climate mitigation) but also avoid “significant harm” to others, such as water ecosystems. Internationally, several jurisdictions have developed or are developing taxonomies inspired by similar principles. China, for example, maintains a Green Industry Catalogue and Green Bond Project Catalogue (2021) which overlap with EU taxonomy categories (and likewise apply a DNSH-like requirement) (CBI, 2019[33]). ASEAN countries, the UK and others have introduced green taxonomy frameworks to define sustainable activities in their contexts , often including criteria for water efficiency, water infrastructure, or avoidance of water pollution as key components (OECD, 2020[34]).

These criteria support supervisors by providing benchmarks for environmentally resilient investments. A project aligned with water-related taxonomy standards is less likely to face future regulatory, reputational, or operational risk, enhancing the resilience of loan and investment portfolios. Under EU rules, banks and insurers must now disclose the proportion of their exposures aligned with the taxonomy (e.g. Green Asset Ratio), creating comparable datasets for risk analysis. Supervisors increasingly use this information to gauge environmental risk alignment and to assess exposure to high-impact sectors (Alessi, Battiston and Melo, 2021[35]). For example, taxonomy non-alignment may signal vulnerability to stricter water regulation or scarcity-induced disruption.

Due diligence enables pre-emptive risk management

Regulatory initiatives on due diligence compel companies to proactively identify, manage, and mitigate environmental and social risks, rather than only disclose them. The EU’s newly adopted Corporate Sustainability Due Diligence Directive5 (CSDDD, 2024) introduces mandatory human rights and environmental due diligence obligations for large companies, including non-EU firms with substantial EU turnover​. Environmental impacts covered span climate change and broader ecosystem degradation – implicitly including water pollution, overuse, and ecosystem impacts. In essence, CSDDD aims to “ensure that companies identify and address adverse human rights and environmental impacts of their actions inside and outside Europe”​ (European Commission, 2025[36]). This shifts corporate behaviour from a passive compliance stance to an active risk management approach regarding issues like water scarcity, water quality, and the rights of communities to water. Complementing this, the OECD Guidelines for Multinational Enterprises (updated in 2023) and related OECD due diligence guidance provide an international benchmark for responsible business conduct (RBC). They recommend that enterprises perform risk-based due diligence to avoid or mitigate harm across areas including the environment. The 2023 update explicitly strengthened recommendations on climate change and biodiversity, reflecting urgent environmental priorities (OECD, 2023[37]). These guidelines (along with the UN Guiding Principles on Business and Human Rights) underpin many national due diligence laws and industry codes. Notably, they extend to the financial sector: for example, OECD’s guidance for institutional investors and lenders outlines how banks should conduct environmental and social due diligence on clients as part of RBC.

Due diligence frameworks function as an early warning system for water-related financial risks, enabling companies to identify and mitigate vulnerabilities before they escalate into material losses. By addressing risks upstream in their operations or supply chains, firms reduce the likelihood of regulatory sanctions, business disruption, or asset devaluation, thereby protecting the financial institutions that finance them. Supervisors benefit from this proactive risk management. Banks with clients that implement strong due diligence are less likely to face sudden credit or operational losses due to water stress. Furthermore, many firms now disclose key risk information publicly, offering banks and supervisors additional data to incorporate into risk assessments and credit decisions. The European Banking Authority has already indicated that integration of due diligence into risk management is a supervisory expectation (EBA, 2025[31]). Banks themselves may fall under due diligence obligations like the EU’s Corporate Sustainability Due Diligence Directive (CSDDD), especially when large enough, and are expected to align ESG strategies with such frameworks.

5.3.3. Collaborative governance bridges the financial and environmental agendas

Although financial risk management and water resource management involve different primary actors, coordinated action is essential where water-related financial risks are most acute. Water issues bridge the financial and real economies; a drought can reduce farmers’ output and impair their loans; a city’s flood defences can determine the scale of losses for insurers and lenders. To address such intertwined risks, financial supervisors can highlight where risk is accumulating in portfolios, while governments and businesses reduce the underlying environmental drivers. For instance, if stress tests reveal that banks are heavily exposed to firms in a water-stressed basin, supervisory action (such as limiting risk concentrations or adjusting loan pricing) must be matched by real-economy responses, for instance investing in water infrastructure, enforcing sustainable abstraction, or encouraging economic diversification.

Recent analyses underscore the value of such collaboration. The DNB’s flood scenario study concluded that a “proactive approach to managing flood risk” by both banks and policymakers is needed to keep the financial system resilient under increasing extreme weather events​ (Coloia and Jansen, 2021[38]). In practice, this means aligning financial sector incentives with climate adaptation efforts. For instance, banks and insurers working with municipal authorities to improve flood defences, which in turn lowers potential losses for the financial sector and the community at large. The Bank for International Settlements has similarly noted that coping with climate-related risks (and by extension, water-related risks) is a “complex collective action problem” requiring coordinated efforts from governments, the private sector, civil society, and international bodies. Central banks can contribute by facilitating dialogue and data-sharing between financial institutions and environmental agencies, and by ensuring that prudential standards encourage, rather than hinder, sustainable investment (Bolton et al., 2020[29]).

A mosaic approach is required. Lasting solutions demand joint strategies, especially where water-related risks are most material. Aligning supervision with adaptation and sustainability policies will yield stronger outcomes. Transparency plays a bridging role: disclosure initiatives (e.g. Pillar 3, CSRD, CDP) empower investors, regulators, and public authorities to act on shared information. For example, public data on a bank’s water-exposed portfolio can trigger corporate engagement and guide government decisions on infrastructure or land use. Through collaborative action and better information flows, financial and real economy responses can reinforce, rather undermine, one another.

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Notes

← 1.  More information: https://finance.ec.europa.eu/capital-markets-union-and-financial-markets/company-reporting-and-auditing/company-reporting/corporate-sustainability-reporting_en

← 2.  More information: https://sasb.ifrs.org/standards/

← 3.  More information: https://finance.ec.europa.eu/publications/commission-simplifies-rules-sustainability-and-eu-investments-delivering-over-eu6-billion_en

← 4.  More information: https://finance.ec.europa.eu/sustainable-finance/tools-and-standards/eu-taxonomy-sustainable-activities_en#:~:text=The%20EU%20taxonomy%20is%20a,environmental%20goals%20other%20than%20climate

← 5.  More information: https://commission.europa.eu/business-economy-euro/doing-business-eu/sustainability-due-diligence-responsible-business/corporate-sustainability-due-diligence_en