Challenger banks were supposed to revolutionise the banking sector by reducing the big banks’ control over the market. Investors seemed to think that the revolution was a fantastic idea as this time last year, shares in challenge banks such as OneSavings (LSE: OSB) and Virgin Money (LSE: VM) were trading at a premium to the wider market and their larger peers.

Over the past nine months, however, the challengers have been hit by a wave of negative news, which has sent investors running scared from the sector.

Problems problems 

The first issue to hit the industry came earlier this year when George Osborne announced that he was replacing the tax on big banks’ balance sheets with a flat 8% profit surcharge tax on banks of all sizes. Not only did this change reduce the burden on big banks but it also made it harder for small challengers to compete with larger peers.

Then the post-Brexit confidence shock hit the sector, and this has ultimately been more damaging than George Osborne’s new tax. Concerns about how the UK economy will fare after Brexit, along with the Bank of England’s decision to cut interest rates further have really dented challenger bank investor confidence. Low interest rates actually penalise challenger banks as they’re required to hold higher levels of capital reserves than their larger peers. Higher reserve requirements mean that challengers can’t loan out the money on their books to generate a higher return on equity. Instead, these banks have to make do with earning almost nothing on reserves held back to appease regulators.

The scale of the challenge now facing these banks can be seen clearly in the City’s revised expectations for growth for the next two years.

Deteriorating outlook 

Back in May, City analysts were predicting OneSavings’ pre-tax profit to increase by around 20% this year while earnings per share were projected to grow by around 9%. Further earnings per share growth of 11% was pencilled-in for 2017. Current City forecasts are nowhere near as optimistic. Analysts are now predicting pre-tax profit growth of 29% in total over the next two years and earnings per share growth of only 11%. Good by some standards, but not what had previously been expected.

Meanwhile, analysts have revised Virgin’s earnings per share growth estimates from 40% this year and then a further 31% during 2017, to 33% this year and 9% during 2017.

Nonetheless, despite the challenges these small banks face from an investor’s perspective they’re still relatively cheap. Specifically, even though Virgin’s growth forecasts have been revised lower the company is still trading at a forward P/E of 9.6, which is cheap for a company growing earnings per share at 33%. Further, shares in OneSavings currently trade at a forward P/E of 6.6, making the bank one of the cheapest stocks on the market.

Foolish summary

So overall, shares in OneSavings and Virgin may have taken a beating recently, but it’s not the end of the line for these banks. Growth is still expected this year, and both banks currently trade at attractive earnings multiples, which discount some of the headwinds facing the industry.

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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.