You can select a bios (Search Switch Settings) while the xbox is on or off, but when it is off you are selecting the bios bank to boot up to.
When you change the switches while it is on, you are selecting the bios bank to flash to using FlashBIOS.
With the X3 bios running, you don't need to select the switches for flashing to different bios banks, which is done by selecting a bios bank with the software.
FlashBIOS is just 256k. The 1MB is just reading the first 256K still.
You modchip comes in default with 2 versions
FlashBIOS 3.0.1 (Works fine for Xbox version 1.0 -1.6)
FlashBIOS 3.0.3 (Works fine for Xbox version 1.0 - 1.5 and 1.6B) Not 1.6
Your backup bios is FlashBIOS 3.0.1, so if you have a 1.6b you should update it with FlashBIOS 3.0.3.