The Labour party is facing a major financial crisis after the scandal stricken Co-operative Group told its MPs that they will slash their funding as part of a review of their historic partnership.

At least a third of the £850,000 annual donation given to Ed Miliband's MPs is to be cut, with one senior Labour figure admitting that he believed all funding from the mutual could soon be stopped.

Such a move would be a major blow for Miliband in the runup to the general election, as it comes after the GMB union's decision to cut their £1m a year funding to Labour by 90%. It is feared that other affiliated unions could make similar announcements before 2015.

The development comes as the Observer can reveal that local authorities across Britain have been warned by financial advisers to urgently remove their money from Co-op bank accounts in the wake of the recent crises, including the arrest of Rev Paul Flowers in connection with the supply of class A drugs.

Mark Horsfield, director at advisers Arlingclose, whose clients include 30 local authorities which bank with the Co-op, said the situation was getting worse by the day as the bank was being buffeted by scandal. Headteachers managing school budgets have also been told to "watch out with the Co-op" by their local authorities on his firm's advice, Horsfield revealed, prompting concerns of a wider run on the bank.

"Such is the nature of the deterioration, we have advised clients to sweep any exposure of bank accounts in the Co-op," he said. "We have not only issued the advice but have made sure it is implemented. Many of them [the local authorities] had already come to that conclusion, but we have been reiterating and published advice again on Thursday softly reminding clients, and keeping it at the top of our agenda."

Around 150 local authorities are believed to bank with the Co-op and Horsfield said he believed other consultants would be offering the same advice.

A Co-op Group spokesman said the most recent figures, for the first half of the year, including the period since credit agency Moody's downgraded its rating, showed that £1.6bn in corporate deposits had been taken out of the bank. He believed retail deposits, where cash is not being held for investments, were currently "broadly stable".

As the scandal has rocked the Co-op, a Labour source said that informal contact had been made with senior politicians to warn of an impending cut to funding for the 32 MPs who are members of both Labour and the Co-operative parties.

The MPs most affected by the Co-op cuts met in private in the Commons Boothroyd room on Wednesday. Barry Sheerman, MP for Huddersfield, who attended the meeting, said: "There is no doubt there is going to be a 30% cut across the board."

Donations from the Co-op Group go to MPs and councillors who represent Labour and the Co-op party, an affiliated organisation which, after running costs, spends its money on the election campaigns of the MPs. Labour MPs have become particularly concerned for the future of the Co-op Group after it emerged that the mutual is now being advised by Quiller Consultants, whose senior executives include David Cameron's former special adviser, Sean Worth, and George Bridges, a close friend of George Osborne and former campaign director for the Conservatives under Cameron when in opposition.

When approached to explain their role with the Co-op, Worth emailed: "We are advising the Co-operative Group, as we declare on the Association of Professional Political Consultants register, but do not discuss client matters."

This week will be crucial for the Co-op Bank and the wider group. By Friday, bond holders in the bank need to vote on a rescue plan; failure to do so could force the Bank of England to step in, with possibly serious ramifications for its account holders. The Co-op Group needs hedge funds to step in and take a 70% stake in the business to plug its financial black hole.

Last week the government announced two independent inquiries into the Co-op Bank and the embarrassing flow of revelations about Flowers prompted by claims in the Mail on Sunday last weekend. Video footage and text messages in the paper allegedly provided evidence that Flowers had purchased class A substances, including crystal meth, while planning "a drug-fuelled gay orgy".

The Financial Conduct Authority later announced an inquiry into the behaviour of key individuals at the Co-op in the period when a £1.5bn black hole in its finances emerged, largely due to a disastrous acquisition of the Britannia building society. A separate more general inquiry ordered by George Osborne, will be conducted by the Prudential Regulation Authority.

It later emerged that Flowers had resigned as deputy chairman of Co-op Group in June because of concerns about his misuse of expenses; that he had two criminal convictions; and that he had left a drug charity after an investigation into his expense claims. It also emerged that he had resigned his position as a Labour councillor in Bradford after "inappropriate but not illegal" pornography was found by IT staff on his work laptop.

Last week the prime minister described the bank's former chairman, a Methodist minister and former Labour councillor, as the "man who has broken a bank".

■ Ed Miliband has hit out at David Cameron for using the Paul Flowers scandal to attack his party's links to the co-operative movement. In a strongly worded attack in the Independent on Sunday, Miliband accused the prime minister of resorting to a strategy of mud-slinging in an effort to win the 2015 election.

Miliband said Cameron "hit a new low by trying to use the gross errors and misconduct of one man, Paul Flowers, to impugn the integrity of the entire Labour movement".