1. A bigger internal hard drive is better. You get more compatibility due to the filesystem used by the PS3 for the internal drive being capable of handling files over 4Gb in size, which the external hard drive's filesystem can't handle. So if a game has a file of over 4Gb, it won't be able to back it up correctly ONLY on an external hard drive. The reason why it 'WAS' a problem specific to downloaded games was the simple fact that we didn't had some software/homebrew capable of reading, writing, transferring to the internal HDD. CJPC just released an FTP server homebrew that let us access the hard disk drive from our PC. This essentially means we can now directly transfer a downloaded game from our PC right into the internal hard drive of the PS3.
2. You don't need to have an external hard drive, but most of them have more storage. So you chose between a little bit more compatibility or being able to put more backups on the same drive. The max storage you can get in an internal 2.5 inch HDD is 500Gb, which is around 30 games. It's alot in my opinion.
3. If backups on optical discs are supported someday (which I think will come REALLY soon if someone decides to add filesystems support), you will probably be able to burn some few games on DVD+/-DL.