It is increasingly being felt that a sound and resilient financial system and the orderly evolution of financial markets are key prerequisites for economic progress. Indian financial system has undergone significant changes over the years. After, independence Indian economy favored intervention in the financial system. However, by the end of 1980s, the Indian financial system was under considerable stress, as the pace of development of Indian financial system had not grown vis-??-vis other developed and emerging market economies. Also, the balance of payment crisis that followed the gulf war of 1990 revealed the indispensability of financial sector development. In the backdrop of the above-presented scenario in order to gear up the process of financial development, India initiated financial reforms in two phases , first in 1991 and then in 1997-98. Since then the Indian financial system has grown vividly with well-diversified and integrated networks of banks, financial institutions, financial companies, financial markets, and new financial instruments. However, with the adoption of the new financial reforms process in 1991 and resultant diversification and integration, the need for a strong regulatory and supervisory framework for the financial system has been felt over the years to prevent it from accompanied vulnerabilities of development. Therefore, at this juncture it is very essential to assess and identify the potential areas of vulnerabilities in the economy, which will help the policy makers to take steps to reduce the threats of financial instability on Indian financial system. This study exhaustively assesses the extent, causes and consequences of vulnerability of Indian financial system to financial instability. The study takes into consideration the pre-liberalization and the post-liberalization eras. The study covers the assessments of all categories of banks, financial institutions and the three major financial markets of India. The co-movement of volatility of stock returns data and the foreign exchange rates with select G-7 and Southeast Asian countries highlight the influence of volatility of these countries on Indian financial markets. Results show that the states of the public sector, private sector and the foreign sector banks and other financial institutions have improved over the years, however, in some cases like in asset quality and profitability they are still far behind in satisfying the prescribed minimum criterions set by Bank of International Settlements. Thus it is very important to take steps to install proper accounting, payment system, technological and risk assessment practices, which help in strengthening liquidity and solvency positions of the banks and financial intermediaries in the course of transition. Also, it required that particular attention should be paid to create and sustain a strong regulatory and supervisory system in accordance with international standards, which will reduce operational difficulties of under-capitalization, non-performing assets, and asset-liabilities mismatches both in banks and financial institutions. This in long term will help to provide strength and soundness to Indian financial system from the events of financial instability. In the present study, we have analyzed the vulnerability of three financial markets of India, namely the call money market, the stock market and the foreign exchange market to events of financial instability. In the case of Indian call money market it was seen that the volatility in the call rates have increased substantially since their deregulation in 1989. So it is proposed that as in other countries, the Indian call money market should also be converted into a fully inter-bank market. The development of Indian stock market has considerably reduced its vulnerability to financial instability. However, there are still many inadequacies that come in the way of performance of Indian stock market. There is need to reassess the too much importance given to liquidities on the securities markets. There is also a need to develop and harness the technique of moral suasion against maximizing purely trading profits. Indian foreign exchange market has undergone lots of transformation over the years. The main course of action to instill stability in foreign exchange market revolves around the composition of the capital inflows. The amount of short-term capital inflows should be reduced in-order to decrease the vulnerability of the market. Apart from above-mentioned policy suggestions framing up of appropriate monetary and fiscal policy, stability in other macroeconomic fundamentals, stability in political situations, proper legal laws, data dissemination and maintenance of transparency should also be taken care of for reducing the vulnerability of the financial system from events of financial instability.