Birmingham City Council could be taken over by central government or broken up if it can't show that it is beginning to improve within 12 months, the Birmingham Post has learned.
Local Government Secretary Eric Pickles is prepared to despatch commissioners to take over departments within the local authority – after taking similar action in the London borough of Tower Hamlets in November.
And the Government will also look at breaking Birmingham up into two or three smaller authorities.
That option was considered by Sir Bob Kerslake, the senior civil servant despatched by Mr Pickles to conduct an in-depth review into the council's failings, who concluded that the cost of breaking up the authority outweigh the benefits – but only "at the moment".
But the council is already on course for confrontation with the Government after announcing it is refusing to accept four of the recommendations in Sir Bob's report.
The attitude of the Labour-led authority was condemned in the strongest possible terms by a senior local Labour MP.
Steve McCabe, a Shadow Education Minister and Labour MP for Birmingham Selly Oak, described the council's response as "just rubbish".
Birmingham City Council's future in its current form has been thrown into doubt by the damning findings of the inquiry led by Sir Bob, the former Head of the Home Civil Service, commissioned by Mr Pickles.
It was prompted by the council's financial issues, the poor performance of children's services in the city and the council's failure to react effectively to attempts to impose an intolerant religious ethos into a few schools, known as the Trojan Horse affair.
But Sir Bob said the council's failings had also contributed to poverty, unemployment and low skills in the city. He concluded: "For Birmingham to achieve its full potential and tackle these challenges Birmingham City Council must do better.
"The overwhelming consensus of those we have spoken to is that the council cannot carry on any longer as it is. We concur with that view."
He accused the authority of failing to provide high quality basic services, such as waste management.
The council blames others for its problems and "too often sees itself as a victim", said Sir Bob. Officers and councillors don't understand their roles, and its "vision for the city" is not understood or shared by residents, local organisations or even council staff, the report said.
A panel appointed by the Local Government Secretary is to examine how much progress Birmingham makes over the next year. The Department for Communities and Local Government responded by warning: "Birmingham City Council has a year to improve its performance or face further intervention."
And Mr Pickles said he looked forward to seeing how the city responded adding: "Be in no doubt that if they do not, the next government may decide to take much tougher action."
The Post has been told that this could mean sending in commissioners accountable directly to the Local Government Secretary to run services, something which has already happened in Tower Hamlets. Another option taken seriously by the department is breaking up the council.
Birmingham has a population of just over a million, but Sir Bob's report warns: "Broadly, for unitary authorities, aside from in relation to transport infrastructure and strategic economic development, the optimum range may be a population between 400,000 and 600,000."
And it states: "There must be demonstrable improvement over the next year or the panel will also need to decide whether further consideration is needed to establish the relative benefits and disbenefits of breaking the authority up."
As transport infrastructure and strategic economic development are to be the responsibility of a planned new combined authority, this would mean splitting Birmingham into at least two authorities.
But the council was defiant in the face of the threats and insists it won't be told what to do by Mr Pickles.
In a joint statement responding to Sir Bob's report, council leader Sir Albert Bore and chief executive Mark Rogers complained about "the presumption, inherent in many of its recommendations, that the people of Birmingham and their city council should be instructed on local affairs from Whitehall."
They said the council "cannot immediately accept" four of the report's recommendations, including Sir Bob's call for the council to develop a financial plan for future years which doesn't involve hoping the Government will provide extra funding. The council also rejected Sir Bob's call for changes to the way District Committees work, and rejected calls for the creation of a civic leadership group, with members from outside the council, to create a long-term plan for the city.
Bizarrely, the authority also rejected Sir Bob's call for the authority to press ahead with a combined authority involving "at least" Solihull and the Black Country councils – even though it is currently trying to form such an authority – on the grounds that "details such as the membership of this partnership and the decision-making process of the combined authority should be left to the councils concerned".
Birmingham's response covers six sheets of A4 paper and begins: "We are pleased the report recognises that Birmingham is a great city with a proud past and with the potential to be at the heart of the most potent regional economic powerhouse of the future."
But it was condemned by MP Steve McCabe, who said: "Reading the first page and half, you would think it had just been told it was the best council in the world.
"You get half way through the second page before they comment on the recommendations. It reads like propaganda. It's just rubbish. They should start off by saying they fully accept things have to change."
He accused the council of "behaving as if it is in parallel universe", planning budgets on the basis of funding from central government which had not been agreed and "producing green papers and white papers as if it was a national government."