It sometimes bothers me that most RPG characters still look like they did when they started their quests while fighting off a game's final boss. For example, the appearance of the main character of Dragon Quest VIII matches his starting equipment and situation very well. However, a yellow cloth jacket and a red bandana don't quite seem appropriate for a hero who is technically equipped with magical plate armor while he is going toe to toe with the Lord of Darkness. Even though RPG heroes typically gain a tremendous amount of power over the course of a game, there is typically no outward reflection of this in their appearance. Creating a difference in appearance goes a long way in convincing the player that he is making progress in a game.
One game series that has done this well is the Fire Emblem series, even though it doesn't use equipped armor to create the effect. Instead, characters get new animations and character models whenever they class-up. So, Micaiah (one of the main characters from Radiant Dawn) goes from wearing simple simple street clothes in her first class to wearing an elaborate priestess outfit in her third class. It does a good job of making her look more capable of fighting the epic battles at the end of the game. Thinking about it, the original Final Fantasy Tactics did something similar by giving the main character, Ramza, new sprites when the player entered a new chapter.
It is possible to achieve this effect by attaching new character models to equipment. Since most RPGs require the player to periodically purchase new equipment in order to stay competitive with monsters, it is possible to gradually improve the matching character models to look more like powerful heroes. At the very least, giving a character's ultimate armor a unique model seems appropriate. However, I think only the main body slot should determine character costume. Making characters look cooler by modifying the character model doesn't work very well if the player is stuck with a jumbled mess. The reason I don't like the way most MMOs handle it is because their approach results in characters with lots of mismatched design elements.
Honestly, I am still not sure whether or not it is better to attach character models to equipment, or to just periodically improve the look of the characters as part of the story. The advantage of using equipment as the basis is that it can better match up with what the character is actually equipped with. For example, a character can look different when wearing cloth armor compared to when he is wearing heavy plate armor. On the other hand, it still results in the problem my brother talked about, which would marginalize more specialty alternate costumes. Either way has advantages and disadvantages.