After a challenging year in 2020, the prospects for Bank of America (NYSE:BAC) look much better in 2021. Despite the many challenges from the coronavirus pandemic, the second-largest bank in the U.S. remained profitable in 2020 after setting aside lots of money for future potential loan losses.

Banks are closely linked to the economy, so a big economic recovery in 2021 would surely bode well for Bank of America. But what if that doesn't happen? Investors should always be prepared for the downside, and if 2020 has taught us anything, it's to prepare for the unexpected. Let's take a look at how Bank of America would fare if an economic downturn persisted and worsened in 2021.

Poor profits but strong capital

The Federal Reserve recently released the results from its second round of bank stress testing this year. Stress testing is an exercise in which the Fed puts the largest banks in the U.S. through a series of hypothetical economic scenarios to ensure the safety and soundness of the banking system. Specifically, the Fed wants to ensure banks are well capitalized in an economic downturn, so they can sustain lots of loan losses and still continue to lend to families and individuals.

Bank of America building

Image source: Bank of America.

Because the pandemic has created such uncertainty, the Fed decided to conduct stress testing for a second time this year. The Fed put banks through two hypothetical scenarios. Although both are very unlikely, 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% 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, 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 about 3.5% from the end of 2019.

If the severely adverse scenario were to occur, the Fed projects that Bank of America would sustain more than $60 billion in total loan losses between now and the third quarter of 2022, which is equivalent to 6.1% of its total loan portfolio. As you might expect, those loan losses would hurt earnings significantly and result in the bank losing more than $30 billion between now and the third quarter of 2022 For context, at the end of the third quarter of this year, Bank of America had set aside about $21.5 billion for potential future loan losses, which is equivalent to about 2.07% of its total loan portfolio.

Although the severely adverse scenario would be a very bad situation, Bank of America would be able to sustain all of these loan losses and maintain extremely strong capital ratios. In this scenario, Bank of America'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 drop from 11.6% now to 9.5%.

At that level, Bank of America would likely still be able to pay its normal dividend, which is pretty remarkable all things considered. The bank would also experience a smaller percentage of total loan losses than any of the other big four banks, including JPMorgan Chase (NYSE:JPM)Citigroup (NYSE:C), and Wells Fargo (NYSE:WFC).

What to expect from Bank of America

A severely adverse scenario with 12.5% unemployment and 3% drop in GDP in 2021 would clearly be extremely tough for Bank of America. It would result in more than $30 billion in losses between now and the third quarter of 2022, and likely in a big dent in Bank of America's stock price, considering banks trade heavily based on earnings.

But Bank of America could clearly sustain all of the loan losses, still be well capitalized enough to lend, and likely continue to pay some level of capital distributions to shareholders. That puts it in immensely better shape than during the Great Recession, and really is a huge accomplishment for the stock when you consider just how difficult the severely adverse scenario would be.

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.