Deffinately a bloat idea (one which may already be planned? A search option for the dev files would be nice...), but one that I feel would add a lot of flavor to the game.
Even in the medieval ages, kingdoms had banners. Individuals had banners as well. My proposal is to give the nations, locations, and people of the game banners, even if it was only described (in medieval terminology of course) and not actually displayed in-game.
As I see it there woudl likely be 3 levels of flag: individuals of particularly high status would be granted coats of arms. In game terms this would likely be nobles and legendary workers/axe lords etc. Above that, locations of note would have a flag associated with them. In game terms this should perhaps not be granted until the arrival of one of the upper nobles, i.e. a mayor or governor. Finally there would be the national flag, which would be associated with your location from the moment you found it.
These could (once dyes have been fully implemented) then be emblazoned on their clothes, shield, and on large pieces of cloth to make flags and banners, which could then be hung on flagpoles and bannerstands (or on walls perhaps?). Flagpoles could hold multiple flags but can only be built outside (not much wind inside the cave, not to mention room), while a bannerstand could only hold one. Bannerstands could possibly be carried as well. As to the effect... likely a flag would make people happy, moreso if it's more closely associated with them. If happyness affects combat ability these could be carried to battle to keep dwarves reassured and make them fight harder.
Plus it'd make some cool room designs.