Why does Adverse Selection lead to inefficiency? (An example of adverse selection in the banking sector)

Adverse selection leads to inefficiency because of imperfect and asymmetric information available with both the parties. This leads to the good being underproduced which means inefficiency. As we saw above in the car market example that the problem of adverse selection leads to underproduction of good cars which results in inefficiency in the market. Problem of inefficiency can also be cited through the example of adverse selection in the banking sector.
Suppose there are two types of loan seekers in the market: ones who will invest the money in projects with lower risk and the ones who will invest the money in projects with higher risk. Then, the ones who are willing to invest in projects with higher risk will more actively seek the loan because they know that they are unlikely to pay it back. Thus, the chances of bad credit risks will increase.
Thus, the banks might not be willing to lend loans because they know that there are more chances of bad credit but they don’t know exactly which is a good credit risk and which a bad one is. Hence, they might not lend even to the good credit risks in the marketplace. This will lead to inefficiency in the banking sector. However, banks generally tend to avoid this problem by collecting enough information about the debtor before lending loans.