Italy has long seen a merger with a stronger peer as the best solution for the Tuscan bank and hired advisers to secure a deal last year.
But the sources said the terms demanded by UniCredit after it entered exclusive talks on July 29 have made the deal too costly an alternative to a standalone plan.
UniCredit had put forward requests for a recapitalisation package worth more than 7 billion euros which the Treasury deemed "too punitive" for Italian taxpayers after they spent 5.4 billion euros to salvage the bank four years ago, according to one of the sources.
"No deal is possible under UniCredit's conditions right now. But the same framework that was offered to UniCredit could be applied to a standalone plan," one of the sources said.
UniCredit, Italy's No. 2 lender, and the Treasury declined to comment.
Rome has already reviewed the possible benefits of a standalone strategy, which would see the Treasury implementing parts of the measures offered to UniCredit, including a capital increase worth several billions of euros, the source said.
Italy is likely to overhaul MPS' leadership to deliver the plan which would see the bank's remaining soured loans transferred to state-owned bad loan manager AMCO and its legal risks carved out and guaranteed by the state, this source said.
Meanwhile, the European Central Bank (ECB) has yet to see a standalone plan, a source close to the matter said, but it has no immediate concern over MPS's capital position.
MPS envisaged in January a 2.5 billion euro cash call if it failed to find a partner and the central bank's supervisors would need to approve any capital increase.
But the European Commission's Directorate-General (DG-COMP) will have the last word on MPS' fate having requested a disposal plan to be ready by a Dec. 31 deadline.
While DG-COMP may well grant an extension, it is unlikely to back down altogether from demanding a sale, this source said.
UniCredit had started discussing a possible purchase of MPS under previous CEO Jean Pierre Mustier. But his successor, Andrea Orcel, who took over in April, raised the bar, targeting a deal for only the most profitable parts of the bank which generate roughly 600 million euros in annual income, according to one of the sources.
UniCredit had said it wanted only MPS' branches in wealthier northern and central regions, and would not take any soured loans or risks stemming from mismanagement.
After concluding its due diligence analysis in September, UniCredit presented the Treasury with detailed demands based on the July terms earlier this month. It aimed to reach a decision before an Oct. 27 board meeting to approve quarterly results.
The sources said the parties had found it impossible to bridge differences over MPS' recapitalisation needs, with one person saying the valuation gap stands at about 2.5 billion euros.
To complicate matters, disagreements resurfaced this week over the assets to be sold, with the government pushing to include MPS' capital services arm and its leasing and factoring unit, two sources had said.
In addition, negotiators haggled over the way UniCredit calculated its fair value adjustments on MPS' liabilities, which became another major stumbling block along with the size and costs of job cuts that Italy had to provide for, the first source said.
($1 = 0.8593 euros)
(Reporting by Pamela Barbaglia in London and Valentina Za in Milan; additional reporting by Giuseppe Fonte in Rome and Francesco Canepa in Frankfurt. Editing by Frances Kerry, Mike Harrison and David Evans) ((email@example.com; +442075427723;))