TOKYO, June 19 (Reuters) - Japan must create an environment where government bonds remain an attractive investment for financial institutions, such as by issuing shorter-duration debt, a finance ministry panel is likely to say in a draft proposal reviewed by Reuters.

The proposal highlights how the Bank of Japan's exit in March from its radical stimulus is prodding the government to prepare for an era of rising interest rates, which will increase the cost of funding the country's huge public debt.

The BOJ also decided last week to start tapering its huge bond buying and reduce its holdings which, at 589 trillion yen ($3.7 trillion), make up roughly half of total Japanese government bonds (JGB) sold in the market.

The diminishing presence of the BOJ heightens the need for the government to find stable buyers of JGBs and avoid a bond selloff that could trigger a damaging spike in yields.

"There is some scope for banks to increase their holdings of JGBs," the draft proposal said, adding that private banks can play a "big role" to ensure Japan can keep selling debt smoothly in the market.

Private banks reduced their holdings of JGBs to 13.1% as of end-2023, from 41.2% in 2012, as the BOJ gobbled up huge amounts of government bonds to push down long-term yields as part of efforts to reflate the economy.

The panel, consisting of academics and bond market analysts, advises the government on how to manage Japan's huge debt. It is likely to submit the proposal to the government on Friday.

The proposal will be among factors the government will take into account in compiling its debt issuance plan for the next fiscal year beginning in April 2025.

The government must reduce the interest-rate risk investors bear by holding JGBs, such as by issuing shorter-duration debt and introducing floating-rate notes, the draft proposal said.

Issuing shorter-dated bonds would mark a turnaround from the government's long-standing approach to issue long-term JGBs to lock in cheap funding, and take advantage of Japan's ultra-low interest rate environment.

The draft proposal also urged the government to consider reducing issuance of super-long JGBs as life insurers, which have been major buyers of such notes, are unlikely to increase their holdings significantly.

"It's also important to cultivate new holders of government bonds," the draft proposal said, calling on the government to boost efforts to attract individual and overseas investors to hold more JGBs.

The BOJ ended its negative interest rate and bond yield control policy in March in a landmark shift away from a decade-long, radical stimulus program.

With inflation exceeding its 2% target for two years, it has also dropped hints that it will raise short-term rates to levels that neither cool nor overheat the economy - seen by analysts as somewhere between 1-2%.

Even a slight increase in interest rates will boost the cost of Japan's huge public debt that has ballooned to twice the size of the country's gross domestic product (GDP).

($1 = 157.8000 yen) (Reporting by Takaya Yamaguchi; Additional reporting; Writing by Leika Kihara; Editing by Jacqueline Wong)