VMware VCB 1.5 Problem with not just using local drives ?

Firstly, I wouldn't recommend that you load your VCB proxy on a VM. That would just add too much load when the backups are running.
VCB normally works in the sense that whether you choose a filelevel or full backup, the VM(s) that you backup are copied/mounted to a 'local' drive on the VCB Proxy Server (which can be NTFS since VCB can only be loaded on Windows machines).
Once the VM is mounted or copied to the local drive, you then use your backup software (if you use e.g. Netbackup) to backup your VM to tape, disk etc.
Since I don't understand exactly where you want to actually backup your VM's, I would say that as long as you have enough space on your VCB server you should be able to backup. Since I don't have too much experience with iSCSI, I could also say that you could map a drive to an ISCSI LUN (formatted as NTFS) from your VCB server and then use that as the 'target' for your VCB Backup?  
Does this make sense?

Yes.
Can you confirm that the VCB proxy server cannot have any other disk drive letters to external NTFS storage. This will conflict with diskpart and discovering vmfs LUNs ?

Well I know that our VCB proxy has mapped drives to other NTFS or even Novell partitions and it works normally so I would say that the VCB proxy can have other drive letters to external storage.
In our case, VCB in conjuction with Vizioncore writes to a data domain box which is mapped on the VCB server as a normal network drive!