The economy looks like it's poised for a big recovery in 2021 given where we stand right now with vaccines for the coronavirus. But if 2020 has taught us anything, it's to be prepared for the unexpected. So, if the outlook takes a turn for the worse and doesn't recover in 2021, it's important to know and understand the potential downside.

Given how closely a large bank like Wells Fargo (NYSE:WFC) is linked to the economy, let's take a look at what might happen if the economy doesn't recover in 2021, but actually gets worse.

Understanding the downside

The Federal Reserve recently released the results from its second round of bank stress testing this year. Stress testing is an exercise the Fed conducts every year on the largest banks in the U.S. to ensure the safety and soundness of the banking system. The goal is to make sure banks are well capitalized in a difficult economic scenario, so they can absorb unexpected loan losses and continue to lend to families and individuals.

Wells Fargo

Image source: Wells Fargo.

This year, because the pandemic created such an unpredictable economic scenario, the Fed decided to conduct stress testing for a second time. The Fed put banks through two hypothetical scenarios. Although both are very unlikely from the current outlook right now, I am going to focus on the one that could still technically occur.

In this "severely adverse scenario," unemployment would rise to 12.5% at the end of 2021 and then drop back down to around 7.5 percent by the end of the scenario. Gross domestic product would decline by about 3% between the third quarter of 2020 and the end of 2021. The scenario also features a sharp slowdown abroad. To put this all in perspective, actual unemployment in the U.S. at the end of November sat at about 6.7% and GDP at the end of the third quarter had dropped by about 3.5% from the end of 2019.

It's a long shot, but if the severely adverse scenario happened, Wells Fargo would suffer close to $60 billion in loan losses over the next two years, or the equivalent of 6.5% of its total loan portfolio. For context, Wells Fargo has currently set aside enough capital to cover losses on 2.22% of its total loan book. So if this severely adverse scenario played out, the bank would need to set aside almost another $40 billion for loan losses, which would eat directly into earnings.

The good news -- if there is any in a scenario like this -- would be that Wells Fargo's common equity tier 1 (CET1) capital ratio, a measure of a bank's core equity capital expressed as a percentage of its risk-weighted assets, would only drop to 8.7%. That's lower than the bank's 11.4% CET1 ratio at the end of the third quarter, but would still leave the bank well capitalized enough to continue to lend in this really difficult economic scenario.

The Fed also projects that in the severely adverse scenario, Wells Fargo would generate pre-provision net revenue of $39.4 billion, take a credit provision for potential loan losses of $52 billion, and suffer trading losses of $10.4 billion. Ultimately, the bank would lose more than $25 billion between now and the third quarter of 2022.

What to expect from Wells Fargo

Obviously, a severely adverse scenario like this would result in a huge struggle for Wells Fargo. Banks trade heavily based on their earnings, so I would expect Wells Fargo's stock to take a significant hit if this scenario played out.

The silver lining in all of this is that the bank has plenty of capital to be able to absorb $60 billion in loan losses. Currently, Wells Fargo has only planned for about $20 billion in total loan losses, and I think most bank CEOs expect to see much less in actual losses when everything is said and done. But this shows a degree of safety, and shows that Wells Fargo would be able to survive and continue to lend in some really difficult economic scenarios.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.