Japanese banks' large holdings of government debt and slow economic growth are challenging the profitability and functioning of the financial system, the International Monetary Fund said Thursday.

In its latest assessment of Japan's financial system, the IMF said deep rooted factors that pose risks to financial stability should be addressed. Deflation and country's aging population are some of the major issues.

Although financial system appears resilient to severe economic distress, long-term fiscal pressures, deflation, and slow growth are risks to the stability of the financial system.

The IMF warned that the massive holdings of government bonds would leave it exposed to a spike in market yields, from levels that are close to zero. Further, bank profitability may remain weak and credit risk may rise, if economic recovery slows.

RTTNews